CPD: Environment, social and governance risks are financial risks – when looking at ETFs

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Understanding ESG characteristics may certainly shed light on risks that need to be managed or considered.

Over the past 12 months many clients have been looking for funds where the role of environment, social and governance (ESG) factors in adding value to an investment practice have been highlighted.[1]  In addition to this, there has been a number of new Exchange Traded Funds (ETFs) in the market with a focus on ESG factors and indexes.  When reviewing these funds it is worth taking a look at Russell’s CPD “A checklist when considering ETFs” in conjunction with this paper on what to look at when considering ESG Investments.

We share three proof points of the value-add associated with ESG awareness and integration, and analyse the importance of considering ESG risks both in the security selection process and the asset manager selection process.  Investors who are unaware of ESG and do not integrate ESG into their investment processes may be exposing themselves to additional, unnecessary and possibly unrewarded risks.

Proof point #1: Selecting securities without considering ESG may be risky business

On April 20, 2010, the Deepwater Horizon oil drilling rig, located in the Gulf of Mexico, exploded – killing 11 workers and creating the largest oil spill from a drilling rig in history. Eventually, 4 million barrels of oil poured into the Gulf of Mexico, creating extensive damage to air, water and recreational quality along coastal states. Marine life, fisheries, land and air wildlife, businesses and port users were all severely impacted. Ultimately, the damage just to natural resources was estimated at $8.8 billion.[3] BP (formerly known as British Petroleum) lost 51% of its market value in 40 days following the explosion, and ultimately paid $28 billion[3] in response and clean-up efforts.

What made headlines about the Deepwater Horizon spill was the environmental impact. We heard less about what was truly behind that environmental disaster – the below-peers safety practices[4] that fostered the explosion (a social characteristic) and the lapses in oversight[5] and accountability (a prominent governance issue). This leads to the fundamental question – should we have known?

BP’s governance issues were well-known and easy to discover by quality security analysis. As the Harvard Business Review put it in 2010, “BP must also clean up an organisational and cultural mess … Lapses seem to have been everywhere; e.g., in preparedness, alert systems, communication, and worst case scenario plans.”[6] Likewise, BP’s safety issues were also well-known and easy to discover by quality security analysis. With multiple fines for violating laws regarding hazardous waste going back to 1990, the company had “one of the worst worker safety records among large industrial companies operating in the United States.”[7] The combination of lapses and poor worker safety should have been red flags for anyone reviewing these securities.

Considering ESG is consistent with good securities analysis that has always been part of a review and selection process.

Proof point #2: Asset managers may improve outcomes by considering ESG risks and opportunities

As part of this white paper we have evaluated the return differential from asset managers who integrated ESG well into their investment practice relative to those who did not. In addition, we evaluated the return differential from equity products with lower ESG-related risks to those with higher ESG-related risks. In both cases, we found evidence that considering ESG produced a return premium.

Proof point #2.1 Qualitative ESG rankings for equity and fixed income

As part of our investment process Russell Investment has, since 2014, ranked active managers on their ESG consideration and implementation, based on qualitative assessments of their processes, product by product.[8] In examining excess returns by ESG rank groupings, we found a modest return to higher ESG-ranked equity and fixed income products, shown in Table 1 below.

In reviewing the left half of the table, we noted that length of the historical period matters in evaluating equity returns:[9]

  • Jan 2015-Dec 2019 (5 years, annualised):Higher ESG rank products exhibited a statistically significant return premium.
  • All shorter historical periods: Higher ESG ranked products exhibited a statistically insignificant return premium.

In reviewing the right half of the table, we observed almost exactly the opposite time effect for fixed income products.

  • Jan 2019-Dec 2019 (1 year, annualised) and Jan 2017-Dec 2019 (3 years, annualised):Higher ESG rank products exhibited a statistically significant return premium.
  • Jan 2015-Dec 2019 (5 years, annualised) and Jan 2020-Mar 2020 (1 quarter, unannualised)Higher ESG rank products exhibited a statistically insignificant return discount.

Ultimately, it appears that the long-term favours ESG for equity products, but only some periods favour ESG for fixed income products. Moreover, the first quarter of 2020 – punctuated by the broad COVID-19 market event – had an impact on both equity and fixed income markets, but the cross-sectional volatility of active returns precluded any statistically significant differences based on ESG rankings.

Quantitative ESG risk ratings (equity products only)

Russell Investments measures ESG risks in all equity products using an external data provider (Sustainalytics), with lower numbers indicating lower ESG-related risks.[10]

Because Sustainalytics changed its methodology in 2019, we have a very short history of live data and cannot make strong assertions. We can, however, evaluate Q4 of 2019 and Q1 of 2020 excess returns using the live Sustainalytics ESG risk ratings from start-of-quarter risk ratings. We tested the differences in excess returns for several universes and over 1,800 equity products.[11] To provide a historical perspective reflecting the evolving nature of risk ratings data, we used some back-test data for two universesU.S. large cap and global equities[12] – to demonstrate year-by-year differences in excess returns.

In Table 2, we compared the excess returns of portfolios in the two lower ESG-related risk quintiles to the excess returns of portfolios in the higher three ESG-related risk quintiles.

Notably, in four out of five years, portfolios with low ESG-related risks (as measured by this particular metric) produced significantly higher excess returns for U.S. large cap and global equity portfolios. The material exception is 2016. In 2016, low ESG-related risk portfolios produced significantly lower excess returns for these same equity universes.

From this data analysis, we conclude that considering ESG in the investment process may have improved returns for both equities and fixed income portfolios in recent years.

 

Proof point #3: ESG consideration is a standard feature of current investment practice

Our 2019 ESG manager survey demonstrated that the vast majority of managed assets incorporate quantitative and qualitative information into their ESG assessments.[13] A rough estimate of the asset managers, using qualitative and/or quantitative ESG information, suggests that approximately 90% of actively invested asset managers incorporate ESG as an investment consideration. A minority of asset managers – the remaining ~10% – do not have any ESG assessments in their process. Ultimately, these numbers show that ESG is useful for obtaining a comprehensive view of investment opportunities.

In addition, we asked about their motivation for integrating ESG. The survey choices were: superior risk-adjusted returnsbusiness/client-driveninfluence corporate behaviours and ethics. Significantly, nearly 60% of respondents cited superior risk-adjusted returns as a motivation in deciding to integrate ESG into their investment practice, with business/client-driven a strong second-place motivating factor. For only a small minority of asset managers – less than 8% – did non-pecuniary motivations outweigh pecuniary.

Case Study – reviewing ESG ETFs

David and Tina aged 67 and 65 respectively are new grandparents to Ebony aged 3.   They are looking to make an investment of $200,000 as a nest egg for Ebony.  They meet their financial adviser Carl, and explain to him they are wanting to make an investment into a fund that is Environmentally, Socially and Governance (ESG).  They also mention to their adviser that they are looking for a fund that also pays a regular income that can either be taken as income or reinvested.

Carl reviews the market, and utilises the ETF checklist previously published on Adviser Voice

  1. Reviewing the index, each of the ESG Funds utilises and Index, Carl familiarises himself with each of the indexes used by the ETF providers in the universe of ESG Funds and identifies which one will be most appropriate and aligned with his client’s objectives.
  2. Research and Rating Carl proposes a range of ESG ETFs that have ratings from both Lonsec and Zenith
  3. Pricing – the fees for RARI at .45%are reasonable compared with others in the market.
  4. Track record –  Carl reviews a range of rated  funds, their indexes and fees and settles on a fund that has a 5 year track record with Russell’s RARI ETF

Based on this feedback Carl recommends the clients invest in Russell’s ESG ETF RARI.

In addition to this Carl also considers the 3 areas mentioned above as part of the review process and after considering these factors recommends to his clients that they invest in RARI.

The bottom line: ESG is value-adding to a skilled investment practice

Ultimately, there is a growing consensus among the investment management industry that integrating ESG factors into an investment practice is value-adding. Understanding ESG characteristics may certainly shed light on risks that need to be managed or considered, and we believe that returns will ultimately reflect this reality.

 

Take the quiz to earn 0.25 CPD hour:

 

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
[1] Some recent examples are Negative screening and performanceThe unintentional biases of ESG portfoliosDoing well by doing good.
[2] https://www.epa.gov/enforcement/deepwater-horizon-bp-gulf-mexico-oil-spill
[3] https://hbr.org/2010/06/bps-tony-hayward-and-the-failu.html
[4] https://www.corp-research.org/BP
[5] https://www.npr.org/2015/04/20/400374744/5-years-after-bp-oil-spill-effects-linger-and-recovery-is-slow
[6] https://hbr.org/2010/06/bps-tony-hayward-and-the-failu.html
[7] https://www.corp-research.org/BP
[8] As of the writing of this note, Russell Investments has ranked nearly 100% of our high interest managers across equities, fixed income and alternatives. Note that it is more likely that ESG ranks have been assigned to high interest products – these products include Hire (or 4) and Retain (or 3). We have also ESG-ranked many of our Watch (or 2) and Fire (or 1) ranked products, and a handful of unranked products (mostly the A or B). The bias lies in that we have more ESG-rank information on those products we are likely to use and recommend than otherwise.
[9] Note that we do not control for skill in any way, but rather look across the active universes and compare each product with its own benchmark.
[10] We also measure these risks for all Russell Investments’ equity and fixed income funds. Risk ratings require holdings to assess and we are more likely to have holdings for products we are more likely to use and recommend.
[11] Note that the live risk ratings data is slightly different, with more underlying information, than the historical back-tested data exhibited in Table 5.
[12] Approximately 400-650 active products.
[13] See 2019 Annual ESG Manager Survey by Yoshie Phillips.

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