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Classic Low Risk Equities and ESG: A Win-Win Situation?

by Patrick Oberhaensli, on Jul 14, 2019 10:20:00 AM

An Almost Philosophical Discussion

Why are the Environmental, Social and Governance (ESG) criteria especially interesting in the context of classic Low Risk Equities (in a long-only low beta approach) in developed countries? The answer being they clearly go hand in hand: A large (and therefore established) company that is particularly strong concerning ESG, should be less risky in the future than the ones of a typical diversified large cap index as it takes the right risks (and avoids unnecessary or bad risks). This is exactly the topic we will examine in this article.



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ESG Assets Under Management

In Switzerland, the largest part of ESG Assets under Management are apparently (as it is not trivial to evaluate) made up of Institutional Investors while the Private Investors portion remains small. This gives the impression that Private Investors are not yet “convinced” by the trend. If the volumes do grow strongly, it is with a significant varying quality of ESG; between the simple(st) exclusion of a very few stocks up to (high) impact investing.

A quick note beforehand: Contrary to large cap equities compared with small cap equities, ESG strong small cap equities companies appear to have a certain growth tilt. It is logical to assume that innovation, including disruptive modernization, is a key driver in that case.


Value vs. Growth: Examining Quality

The quality factor at a macro scale is linked to value rather than to growth. Although it is a question of definition, innovation is also important to consider in that context, but at a lesser degree (certainly for smaller companies).

Examining classic Low Risk Equities based on the low beta anomaly, we saw that a key criteria for the specification of the investment universe is the well below 1 beta of the stocks considered (the reference market itself having a beta of 1).  This is rather “consistent” with value stocks and not with the more risky growth ones.

Moreover, one should expect that for both Low Risk and ESG strong Equities, a prolonged holding period under normal conditions is common – unless a stock gets too expensive. This means that the investments are guided by high convictions and would imply a low turnover.  In such a portfolio, the strategy could easily constitute a core investment within an ESG core-satellite approach.  Therefore, it is highly likely one would be able to implement a rather large intersection of the two universes made up of the Low Risk Equity and strong ESG companies.


Is a Too Simplistic ESG Approach Useful?

Now, how would one proceed concretely? The simplest approach would consist in adding an ESG exclusion layer to the benchmark universe at the very beginning. Depending on the strength (but not necessarily the intelligence) of the exclusion, entire (sub-)sectors would be ignored. The typical activities that are excluded include tobacco and defense-segments (the controversial weapons segment). Normally, these sectors are higher-risk & potentially higher-return stocks, that are less likely to be Low Risk (beta) ones.

The issue is that approaches which are too simplistic are less effective (or of lower quality). The investor needs to carefully study this approach given that there is the potential that they are “oversold” by concerned Asset Managers in order to show high levels of ESG Assets under Management.  On the other hand, if using “a few-stocks-exclusion”, it has the fallacious advantage of being less resource binding.

For independent investors (investing by themselves), a smart Key Risk Indicators method could be an intermediary solution. Certainly an important topic, and we will examine this method further in future articles.


Advanced Methods

A more sophisticated approach would involve the best-in-class ESG stocks for each sector, or at least a classification (within the sectors, including the lesser ones). This aims to effectively favor the stronger and strongest stocks in an extended universe.

It could even take into account, thanks to the engagement activity, the companies that should (or at least have potential) to become ESG “champions” in the foreseeable future.  Engagement refers to when the Asset Manager discusses significant improvements with particular companies, convinced that he/ she can make a positive impact. In a Bank, the focus is not-financing against-proper-ESG activities, for example, the ones related to a very high carbon footprint.

The same by-sector approach can be applied for the Low Risk Equities search, the key criteria being the necessity to consider a large enough universe of stocks (with sufficient liquidity). This simplifies the portfolio construction process in order to keep a closer-to-benchmark sector weighting.

Ultimately, each Asset Manager (and possibly the Investor) will more or less use his/ her own ESG proprietary methodology. There are hardly standards to be found beyond the most basic technique of very limited exclusions with the UN’s Sustainable Development Goals (SDGs) as the common language. That explains, at least in part, why ESG is still not widely present and even less so in combination with the exploitation of a non-fundamental anomaly such as the ones related to Low Risk Equities. A second reason is as follows…


Investment Dimensions More Integrated

In terms of implementations available in the market, it is very difficult to have a proper overview based on extensive figures. A key issue is being unable to understand clearly what the contributions of the different drivers are through the investment pool’s complete history.

For instance, the beta-based LRE strategies might exist for a number of years, but the ESG overlay started much later, becoming more sophisticated with time. In that case, the different reference points and comparisons could become complicated.

What we have found, is that specific providers with a quantitative asset management and more or less extensive ESG capability, have solutions with a certain track record that happens to be quite positive: they are at least outperforming the benchmark which is better than “required” – but one should always be careful about considering specific periods for analysis purposes.

For the investors seeking to add the ESG dimension to their investments, as it is the case for a constantly growing number of Institutional Investors, ESG Low Risk Equities is definitely a strategy to consider. Even though the offering is currently more limited for advanced ESG, more simple applications could be used for the individual investor.


Conclusion

In the context of (very) low interest rates, ESG Low Risk Equities would allow to further optimize the portfolio by reallocating a part of the ESG fixed-income investments. However, while the low beta anomaly is known for a long(er) time, integrating ESG is relatively recent and there can very well be bad surprises (as there have been).  Therefore, the necessity to have an efficient and effective talent recognition process is essential.

 


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Topic:Investment StrategyDiversificationAnalysis and StrategyLow Risk EquitiesESG
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