For this month’s column I would like to draw your attention to two recent articles that have raised my eyebrows. One is on the ESG integration paradox, which got me thinking about our own ESG integration approach, and the second is sin stocks revisited. The latter sheds some more light on the paradox of why many studies show that ESG works, but sin stocks also work. It’s the quality factor, stupid!
The article ‘Smart investing: the ESG integration paradox’ by Michael Cappucci from the Harvard Management Company notes that more than 40 years of academic and empirical evidence suggest that ESG integration in the investment process can lead to better risk‐adjusted returns and long‐term value creation. And the gold standard for sustainable investing is the full integration of ESG factors into the investment process. So why isn’t everyone doing this? And doing it well?
Cappucci argues that before choosing and deploying an ESG strategy, investment managers need to carefully consider both the relevant benefits and expected costs. Potential benefits are long-term and difficult to measure, but costs are immediate and real. So if ESG is not applied in a good way in the investment process, it can actually reduce investment performance.
He goes on to say that even though a substantial percentage of institutional investors believe that full integration is the ESG strategy with the greatest positive performance potential, hardly anyone is practicing it. This is supported by two surveys which show that investment managers want to integrate ESG but clearly do not know how to do it. Several hurdles are mentioned: a lack of comparable data and research; the fact that ESG integration is a fairly new concept in finance, and short investment horizons.
A State Street study indicated that asset owners and asset managers believe that the proper timeframe for expecting ESG integration to deliver outperformance is five years or more, but only 10‐20% use these timeframes for evaluating performance. The conclusion of the paper is that in selecting managers which practice ESG integration, investors need to look for those that have survived the growing pains of early ESG integration, but have not yet reaped the full benefits of it.
After reading the article I could not help but wonder about our own ESG integration. I see the point that Cappucci makes, as after four years of experience we are currently improving our ESG integration approach in our Global Equity portfolios. We are using our experience and the data points to make our framework even more consistent across companies and across analysts. This aims to bringing more structure without losing the integrated thinking, which comes down to a ‘subjective’ fundamental assessment.
We also have discussions on how – or even if – we should measure the added value. As ESG information is integrated into our investment cases, and thus into our decision making, it is impossible to make a clear attribution. We are, however, putting effort into measuring the impact of ESG on our decisions. We have found that in 30% of cases in credits, a fundamental rating is adjusted due to ESG considerations, and for equities, 7% of the valuation in global stocks on average is attributed to ESG factors. In terms of performance, we found that the portfolio of companies for which the analyst increased the target price due to ESG being incorporated actually outperformed.
This reinforces our belief that by structurally using ESG information in our investment processes, we improve our investment decisions. And even though we see enough areas to improve, and we still need more experience, I would like to think we are on our way in the upward slope of the ESG integration pathway.
Yes they do! Over longer periods of time, sin stocks – alcohol, tobacco, gambling and weapons – have outperformed stock markets globally. This is of course a thorn in the side of all those investors who exclude these companies from their investment universe for ethical reasons, and at times deliver some difficult newspaper headlines.
Investors who exclude sin stocks to reduce risks because they expect these business models to be unsustainable have not seen this strategy outperforming. Tobacco companies, for example, face rising sales taxes, ever-increasing warning signs on packaging, and steadily declining smoking rates in US and Europe, though these headwinds have been offset by price increases and growth in emerging markets and thus very good long-term performance. At the end of July however, tobacco stocks were hit by the US FDA’s proposal to reduce nicotine levels in cigarettes. Whether this is the turnaround point that will end decades-long outperformance by these stocks remains to be seen. Analysts are still in love with the sector and see product innovation to less-detrimental cigarettes as an opportunity for some of the names.
In the article ‘Sin stocks revisited’ by David Blitz and Frank Fabozzi, published in the Journal of Portfolio Management, sin stocks are defined as four indus¬tries that are included in almost every study on this topic, and that collectively have been strongly associated with positive abnormal returns: alcohol, tobacco, gambling and weapons. The combined weight of the sin sector averages 2.1% for the US, 3.5% for Europe and 2.2% for global indices. They exhibit a significantly positive alpha in the US, European and global samples used in the academic literature. Interestingly, however, this alpha disappears completely when investors don’t just account for classic factors such as size, value and momentum, but also for the two new Fama-French quality factors of profitability and investment.
So, it is still an issue that over the longer term, sin stocks seem to outperform; but now that it is clear where this performance is coming from, it is also clear what investors may do about this. Investors may restore their portfolios’ expected return by making sure that their factor exposures do not deteriorate when excluding sin stocks. This could be achieved, for example, by increasing the weights of stocks that are able to compensate for the loss in factor exposures that the sin stocks provided.
This is something that fundamental portfolio managers already do – looking for alternatives that have the same characteristics, for example in the staples sector. In our sustainability focused quant products, we also demand a better sustainability profile, reduce the environmental footprint and exclude sin stocks, while at the same time optimizing our factor exposures, thereby having little (but not zero) impact on the expected risk/return of our portfolios.
Finally, I also read an interesting article on the positive correlation between the amount of ESG policies and controversies, even when controlling for size and other effects, entitled ‘A Pitfall in Ethical Investing: ESG Disclosures Reveal Vulnerabilities, Not Virtues’. But I will leave my thoughts on this for the next column!
This is our monthly column on sustainability investing by Head of ESG integration Masja Zandbergen.
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