Iordanis Chatziprodromou asks if there are identifiable risks associated with general ESG-driven investment strategies
When Woody Allen said that money is better than poverty, if only for financial reasons, he most probably didn't have in mind businesses' fiduciary duties. But he certainly managed to give an accurate description of modern businesses' driving principle - profit. Indeed, profit is a valid motive especially when it is enforced by litigation (see pension funds' fiduciary duties; judicious action for proper purpose). Are those that invest in ESG strategies breaching this obligation?
The 2005 Freshfields report states clearly that this is permitted only if the ESG considerations are not systematically diluting profits. At the same time, a fair share of market thinkers are embracing the opinion that, by definition, ESG investment strategies reduce investment and diversification opportunities.
It is useful to clarify that the term ‘ESG integrated investment strategies' does not mean ‘ethical investment' and the application of ‘values-based' negative screens, but rather the incorporation of sustainability criteria into the overall investment decision. The confusion between the two paradigms is often the source of unfortunate research results, misunderstandings and misstatements.
The present article focuses on the work conducted by Darren Lee and Yaokan Shen of UQ Business School, University of Brisbane and Jacquelyn Humphrey from the School of Finance, Actuarial Studies and Applied Statistics, Australian National University, the purpose of which was to investigate the effect of SAM's proprietary sustainability ratings on the financial performance and/or risk of investment strategies.
The approach employed was general and targeted to identify systemic differences between traditional and ESG considered strategies according to modern finance theory. We emphasise the word ‘systemic' and stress that the results explain what would have happened in the past, or in other words if the fair value of general ESG-driven investment strategies differ than the rest under the no information assumption.
For the sake of completeness we are including information about the data and the models used. The research focuses on 249 UK firms for the period 2002-08 (currently the authors are working on a 2009 and 2010 updated data set). The reasons the UK is a good market for such a study reflects the fact that UK companies are obliged to disclose sustainability information under the UK's Companies Act 2006.
In addition, the UK exhibits one of the highest percentages of investment companies employing ESG criteria in their investment process (about 30% of the total assets under management are managed from funds using sustainability data). The universe the authors employ conforms very well to FTSE All-Share index constituents of listed securities. Various techniques are employed to correct for any small dissimilarities that may exist. Both industry-specific and general sustainability criteria are tested and four types of high/low sustainability portfolios are examined:
• Broad portfolios - portfolios of companies with Corporate Sustainability Performance (CSP) values above/below the 50th percentile;
• Conviction portfolios - portfolios of 40 companies with the best/worst CSP;
• Best/worst of sectors (BOS/WOS) portfolios - portfolios of the top/bottom 25% within each of the 20 FTSE All-Share index sectors;
• High/low industry portfolios - portfolios of good/bad industries in terms of average CSP.
Several models were employed to cover the whole spectrum of possible risks that might distort the results. From a simple CAPM to an extended Fama-French model (Carhart, 1997) and an enhanced Carhart model accounting for systemic industry factors (Derwall, 2005) and idiosyncratic risk factors (Lee & Faff, 2009).
In general, the results indicate that there is no systemic difference in the risk-adjusted performance across the range of the portfolios tested (as shown in the table). Controlling for size, style, momentum, industry and idiosyncratic factors did not cause any change in the outcome and the use of general or industry specific CSP measures was also indifferent for the results.
The only strong positive relation identified - which agrees with previous studies (Brammer, Brooks, & Pavelin, 2006, Porter & Kramer, 2002, Udayasankar, 2008) - is that there is a robust connection between size and CSP Table 1. If sustainability factors are incorporated naïvely into a portfolio, without controls, the result is a bias towards large caps. However, this cannot be treated as a separate risk factor as the resulting discount, if accounted for, will be equivalent to a size effect discount without any addition from CSP.
Hence, by controlling for size, the performance of sustainability optimal portfolios wouldn't be systematically different compared to a control portfolio. It is worth mentioning that there is a structural issue that drives this relationship: the inherent difficulties that small companies have to fulfil sustainability demands under the prevailing rating methodologies. ESG measures widely adopted by the industry practically create the size bias anomaly and this is an important topic that raters need to solve. SAM has a strong focus on the issue.
As we've mentioned above, the study focuses on the UK region and that might raise questions about the generality of the results. A recent research piece from Hoepner, Rezec & Siegl, that employs a more global approach, uses EIRIS data and in principle comes to the same conclusion (Hoepner, Rezec, & Siegl, 2011). It can be used as complementary evidence to the results of the UK study.
A very superficial interpretation of the results can lead to the conclusion that there is no obvious benefit from the employment of ESG factors since they are not adding any concrete advantage to the investor's financial outcome. The correct conclusion, though, is that managers can invest in ESG strategies without breaching their fiduciary obligations. Moreover, given recent developments, in the near future investors will risk violating their duties if they do not invest in ESG. The United Nations Environmental Programme (UNEPFI, 2009) articulates this in a very concrete way:
• Fiduciaries have the duty to consider more actively the adoption of responsible investment strategies;
• Fiduciaries must recognise that integrating ESG issues into investment and ownership processes is part of responsible investment, and it is necessary to making risk and evaluating opportunities for long-term investment.
Sustainability investment has been around for some years now but it is relatively unexploited. There are a lot questions to be answered. How are sustainability driven risk factors going to change the structure of the market? What is the intangible value of sustainability? Is it correct to treat sustainability factors in the same way as the financial ones? Are the next market anomalies related to such factors? Such questions and the research around them are dynamically going to change the landscape of the investment industry.
Finally, one cannot ignore the systematic beneficial impact on society from having a long-term approach to investing and managing the world's finite resources and environment in a responsible manner.
Finance is a sub-set of economics and not the other way around. Economics clearly teaches us to manage our resources effectively for the benefit of all mankind - not just a small number of overly wealthy, obsessed individuals. To rely on the short-term unsustainable profits clearly breaches ones fiduciary duty and is not at all in the interests of investors over the long-term.
Iordanis Chatziprodromou is senior analyst at SAM Research AG