ESG as insurance, not for short-term alpha
Investing along environmental, social and governance (ESG) lines has been found to be beneficial for portfolio performance. But it is worthwhile taking a harder look at the true value behind ESG investments, to keep expectations in check. ST PHOTO: LIM YAOHUI
INVESTING along environmental, social and governance (ESG) lines has been found to be beneficial for portfolio performance. But it is worthwhile taking a harder look at the true value behind ESG investments, to keep expectations in check.
For example, research from Scientific Beta published in May said there is a lack of solid evidence that ESG strategies outperform. The paper, titled "Honey, I Shrunk the ESG Alpha: Risk-Adjusting ESG Portfolio Returns", does not dispute that many of the ESG strategies have positive returns. But after adjusting these returns for risks, the "alpha" - that is, the excess risk-adjusted return - stands at zero.
The implication is that in investing along ESG lines, the outperformance may be driven by sector biases or certain equity exposure. That means that using ESG as an "alpha signal" is starting to look misleading, especially when putting money behind improving ESG practices by corporations is mission critical today.
Indeed, Noël Amenc, CEO of Scientific Beta, said in a statement: "Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk."
Applying 'better beta' lens
The danger is that in promoting alpha in ESG investing, such players are taking the great risk of disappointing investors on this supposed outperformance. This diverts money in time from an investment theme that is important for sustainable economic development, said Professor Amenc.
In an article titled "The Future of Sustainability - In Practice", GIC pointed out as well that seeing sustainability as a source of short-term alpha can lead to disappointments, given that corporations and economies are collectively meant to move in a more sustainable direction over time. The article presented takeaways from a panel session at GIC Insights, its annual flagship event.
"Applying a 'better beta' lens will ensure a well-constructed, future-proof portfolio that is likely to generate better, more resilient returns over the long run," said the article.
"Investors should formulate clear, long-horizon strategic goals that incorporate sustainability. Conversely, adding sustainability as an incremental layer to existing investment practices often leads to suboptimal results and to greenwashing, which will not stand the test of time."
More reports are also joining investors like GIC to argue that exclusionary screening - one common approach in ESG investing - does not bring impactful results either.
A recent article in The Journal of Impact and ESG Investing showed that while investors may make large-scale exclusions based on carbon exposure or other broad criteria, such negative screenings have historically had a relatively small impact on long-term returns and risk.
GIC's article noted that exclusion is "not the most productive way to run a portfolio". "Investors should leverage the range of instruments at their disposal to generate better returns per unit of risk and influence positive outcomes. One example is going short in areas that are expected to underperform."
Likewise, Marc Lansonneur, head of managed solutions at DBS Private Bank, said that ESG's benefits are not short-term in nature, but are meant to address structural changes that would impact overall portfolio returns. "They ... serve as portfolio insurance against potential E, S, and G risks, which may impact performance," he told The Business Times.
"The pandemic - and the market volatility it sparked - has impacted many investors, and served as a stark reminder that it is vital to stay well-diversified and positioned for the long-term, and to manage risks in each underlying investment."
He added that the benefits to ESG investing remain unchallenged. "Even in research challenging ESG, their arguments were not about ESG investments underperforming, but about it not outperforming, which suggests that ESG outcomes are positive at best, and neutral at worst," he said.
"In the short run, the market is a voting machine. In the long run, it's a weighing scale. A company which is committed to ESG best practices should ultimately see lower operational risks, and therefore a lower beta (all other things being equal)."
Structural changes are due.
For example, industries with climate-friendly operations are more likely to receive government support or tax subsidies. Those that do not will likely incur fines, penalties, taxes and enforcement actions that restrain future profitability, said Mr Lansonneur.
On a related note, GIC's article pointed out that in the area of climate change, the fundamental flaw is that risk today is not adequately priced.
"Taking into account risk and the worst-case scenarios would imply a higher price today, rather than the traditional notion that price should be low today and rise slowly over time to a higher price in the distant future," it said. "The purpose of risk management is not to minimise risk, but to ensure appropriate compensation for the risk taken."
On the social front, there are heightened cultural sensitivities to social and justice issues, while the proliferation of social media promotes the virality of both exemplary and unbecoming company practices, said Mr Lansonneur. "This means that companies may be unknowingly blindsided by social risks," he added, resulting in financial losses from the likes of product boycotts, regulatory fines, or costly rebranding exercises.
Finally, from a governance standpoint, investors are increasingly attuned to the fact that high-profile governance problems can result in sudden volatility. They are becoming increasingly intolerant of such corporate lapses, no matter how well the stock of these companies have performed over the medium term.
Again, paying attention to governance factors is a means of buying insurance. Corporates already need to make the regularly invest more time and effort to analyse the effectiveness of governance frameworks. Occasionally, the investor sees "large payoffs in terms of loss avoidance in a crisis", said Mr Lansonneur.
Reducing portfolio risk
"Analysing governance factors is a means of downside mitigation, giving an additional dimension to improve the risk-return profile of an investment portfolio."
Besides referencing ESG ratings of single investments, DBS is advocating an ESG portfolio-weighted rating approach. The aim is to provide a simple methodology for clients to invest in a combination of varying levels of ESG-rated and non-rated investments that, together, achieve a certain level of ESG rating for the overall portfolio.
"This approach also allows clients to include ESG investments that have an improving ESG trajectory and other investments to achieve an expected level of risk-adjusted return. Over time, these portfolios provide a good baseline for clients to further adjust their investment portfolio to align with their personal values and investment goals."
Such an approach is especially key in Asia, where companies' ESG ratings are improving but still lag the West.
The bank would advise investors to avoid timing the market - with so much uncertainty still abound, it would be "nearly impossible" for the average person to profit from trading volatility, said Mr Lansonneur. "Stay invested in diversified portfolios and look at secular trends such as sustainability, which are here to stay."
This article was written by Jamie Lee and first published in The Business Times on 4 Aug 2021.
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