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Alternative Market Briefing

Quants make the case how to move ESG beyond long-only equities: White Paper

Tuesday, June 09, 2020

Matthias Knab, Opalesque:

The recent proliferation of ESG funds reflects a surge of interest among investors to align their investment portfolios with their values. While the impetus for the ESG movement signifies a meaningful change in investor behavior, we observe that ESG investment returns are generally disappointing. That is, most ESG funds underperform the market and reflect the same systemic risks borne by passive equity investors.

In a recent White Paper (available here), Welton Investment Partners point to the potential for innovations that make truly material improvements in ESG investment performance. And if so, these concepts may help address today's ESG dilemma: how to advance one's values while also improving the mission of performance?

In particular, Welton believes ESG funds could benefit from the following three design and management techniques:

  1. Integration of timely and broad ESG datasets
  2. Dynamic stock selection and weighting using machine learning techniques
  3. Use of orthogonal strategies to mitigate market risk and enhance performance

Assessing ESG performance of funds with 10+ years track record

To assess ESG fund performance Welton started with the largest ESG mutual funds, screening for those funds with at least 10-year track records and a minimum of $100m in AUM. This yielded a group of 62 funds representing $99bn in assets. This equates to 72% of Morningstar's estimated $137.3bn in total sustainable mutual fund and ETF assets at the end of 2019.

Not surprisingly, the first observation from the sample is that ESG fund assets are almost entirely concentrated within Equity funds as opposed to Balanced or Bond funds. In fact, Equity funds represent 95% of all ESG fund assets in the sample.

Using this ESG universe, Welton observed that the majority of funds have underperformed the wider market over the last decade. The market is represented here by the S&P 500 TR Index which one can consider to be investable its slim +4bps/annum performance differential with the Vanguard S&P 500 ETF (VOO).

There could be multiple performance reasons at play, and probably in combination. ESG funds likely differ from the index, such as sector weighting differences and resulting dividend availability. The S&P 500 may not be the optimal comparison index for some. For example, variations among funds could include: large caps vs. small caps, developed vs. emerging markets, or concentrated vs. diversified portfolios. Even the "ESGness" of funds likely varies, whether in the integration depth of their process or rigidness of their ESG screening criteria. Of course, fees will also impose a material difference between the index and the funds shown too.

Welton's goal is not to settle the question of ESG alpha or offer definitive explanations for each of the funds in its sample but simply observing that approximately 70% of all sustainable mutual fund and ETF assets represented by the 62 largest funds underperformed the broader market over the last decade - sometimes by a meaningful margin.

And whatever the cause, ESG funds do not appear to differ markedly from all other actively managed funds. According to the most recent Dow Jones SPIVA U.S. Scorecard, 96.57% of U.S. large cap core funds were also outperformed by the S&P 500 Index over the last 10-year period.

Investor expectations will vary, and for some, this outcome is an acceptable one. Near-market performance by some funds may be an acceptable trade-off in investors' pursuit of desired social or environmental change. For others, this finding may disappoint. They may see the inherent impairment of their mission if they find themselves on the lower end of this performance spectrum.

Reality Check: ESG mediated risk mitigation

The authors added that examining performance in the absence of risk misses a primary concern. Investors who pursue ESG are not immune to the risks they are taking.

The case for ESG mediated risk mitigation is based on two conjectures. The first is that one can diminish idiosyncratic risk (i.e., company-specific risk) by excluding companies with higher future risk potential relative to their industry group peers. The second is that certain industries, such as oil and gas, have higher inherent industry-specific risks relative to others. Flare ups for both risks, however, will occur episodically and perhaps infrequently, making it challenging to objectively test for incidences of company/industry-specific mitigation among a wide collection of funds.

Systemic Risk

Rather than seek to answer the difficult idiosyncratic mitigation premise, Welton chose instead to examine the more material systemic risk question by focusing on specific periods of acute economic contraction.

Do ESG investors bear the same risks as ordinary passive investors, or do ESG portfolios have additional protections to preserve performance when investors most need it? After all, these events are unquestionably material, and any mitigating properties during crisis periods may even outweigh occasional idiosyncratic controversy risks.

To find out, Welton chose three periods for our analysis. For a bear market period the authors chose the peak-to-trough drawdown during the Global Financial Crisis from October 2007 to February 2009. For a market correction period Q4 2018 was chosen, memorable for its sudden volatility and the swift 14% drop in the S&P 500 at the close of 2018. Lastly, Welton also examined the still-unfolding COVID-19 pandemic period of Q1 2020.

Welton selected the MSCI KLD 400 Social Index as proxy for general ESG fund performance. The KLD 400 is the most prominent U.S. equities-based ESG index that existed back to the GFC in 2007, and its performance and construction make it well suited for comparison. The KLD 400 and the S&P 500 share similar volatilities and it is comprised of 400 North American companies that meet high ESG standards.

Sophisticated techniques commonly used within hedge funds and quantitative investment can make a difference

The White Paper includes three charts (Charts 4 - 6) where it can be seen that the MSCI KLD 400 Social Index mirrored the S&P 500 downward during all three events but with a slight improvement in performance. And while any improvement is certainly noteworthy, the much clearer takeaway from these charts is that ESG investors shouldered virtually the same market risk as passive equity investors. Idiosyncratic risk mitigation is simply overpowered by systemic market risk during crises and corrections alike.

Welton believes opportunities exist to improve ESG investors' experience. As one moves beyond a long-only, equity-centric ESG model, sophisticated techniques commonly used within hedge funds and quantitative investment firms may be beneficial.

At the upcoming Opalesque SKILLSLAB webinar on June 18th, an esteemed panel will discuss three ways this quantitative approach can improve an ESG portfolio's risk/return profile:

  • Basil Williams, CEO & Portfolio Manager for Welton ESG Advantage, Welton Investment Partners
  • Oren Rosen, PhD, CAIA, Porfolio Manager - Systematic Macro and Trend Strategies, Welton Investment Partners
  • Francois Chevallier-Gravezat, PhD, Porfolio Manager - Machine Learning Strategies, Welton Investment Partners
  • Todd Bridges, PhD, Partner & Global Head of Sustainable Investing & ESG Research, Arabesque S-Ray

Register here for this free Opalesque SKILLSLAB webinar:

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