A new approach to SRI

How to survive the next crisis
A new approach to Socially Responsible Investment
April 2011
Contents
3
Introduction /Motivation
5
From extra-financial to financial sustainability
8
Results
10 Discussion & Conclusion
12 Summary
1. Introduction/
Motivation
Lessons from the crisis
Apart from wreaking havoc across the globe, the financial crisis also taught
socially responsible investors two instructive lessons. First, SRI equity portfolios
performed very much in line with the broad market and did not provide a significantly better downside protection. And, second, the extra-financial indicators
currently used were insufficient to detect or prevent certain financial externalities
that proved particularly harmful to the financial system and the economy as a
whole. The objective of this paper is to learn from these lessons and make SRI
a more stable and more effective investment strategy.
No better downside protection
Although the great recession, as it has been dubbed by some, actually vindicated
many of the tenets held dear by social investors, this did not materialise in a
significantly better financial performance of SRI portfolios. This was also the
conclusion of a recent study conducted by the French business school EDHEC 1.
The authors found that although for the period from January 2007 to December
2009, eight out of ten SRI indices did better than their non-SRI counterparts,
the difference was not statistically significant. Likewise, of 120 SRI and green
funds investigated, not one was able to generate a significant positive alpha.
The authors conclude that, on average, SRI funds did not provide protection
against the market downturn.
ESG risks among the root causes of the crisis
The financial behaviour of SRI portfolios certainly calls for an explanation.
Unsustainable business practices such as administering loans to people who
could not afford them, encouraging irresponsible risk-taking through dysfunctional incentive schemes and poor corporate governance practices were certainly
among the root causes of the crisis. One would therefore assume that SRI portfolios, which are explicitly screened for their environmental, social and governance
(ESG) risks, would shield investors more effectively from such a heavy market
shock, triggered at least in part by the very problems the ESG screen was
supposed to avoid.
Of course, SRI equity portfolios remain equity portfolios in the first place and,
as such, they cannot be reasonably assumed to stand firm while the rest of
the world is melting down. Nonetheless, the lack of a significant performance
differential suggests that SRI portfolios were not less risky than conventional
portfolios. Does that mean that ESG filters failed to deliver what they were
supposed to? We do not believe so.
1
The performance of Socially Responsible Investment
and Sustainable Development in France: An Update after
the Financial Crisis. Noël Amenc and Véronique Le Sourd.
EDHEC 2010.
2
The SRI performance paradox. How to gauge and
measure the extra-financial performance of Socially
Responsible Investment. Pictet Asset Management 2008.
3
http://www.unpri.org/files/6728_ES_report_
environmental_externalities.pdf
Introduction/Motivation
Extra-financial screening is necessary...
If done properly, screening companies for environmental and social criteria
can reduce regulatory and operational risks and make a measurable contribution
to reducing related negative externalities. For instance, we have been able to
show that best-in-class portfolios geared towards greater energy efficiency and
social responsibility can substantially reduce CO2 emissions and create more jobs
per unit of capital invested than investing the same amount in a standard index
portfolio 2. Reducing companies’ environmental and social externalities is not
only a worthy cause but a necessary condition for a credible SRI approach.
A recent study by the United Nations Principles for Responsible Investment
(UN-PRI) looked into the question for the 3,000 largest stock-listed companies
worldwide and came up with an estimate of over USD 2 trillion per year,
in environmental damage alone 3.
From extra-financial to financial sustainability
Results
Discussion & Conclusion
Summary
3
...but not sufficient to prevent some particularly negative externalities
This being said, extra-financial analysis is not a sufficient condition for a
truly sustainable investment strategy. SRI has probably not done enough in
the past to screen out companies that produce massive negative financial
and economic externalities. It has not done enough to favour companies and
promote practices that contribute to making the financial and economic system
more sustainable and resilient to shocks.
According to
The Economist,
as many as one
in four American
borrowers is under
water. Over four million
households owe at
least twice as much
as their home is worth 4
4
4
As for the natural environment above, the negative externalities on the financial
and economic system caused by the recent financial crisis are staggering: the
extreme slump in the real economy caused by the credit crunch, the necessity
of massive stimulus programmes that drove up the public debt burden for
generations to come, the loss of millions of jobs, and the many people whose
home equity has turned negative and who are threatened by foreclosure.
Economics focus. Drowning or waiving.
The Economist. Issue October 23rd-29th 2010.
A challenge to the future of SRI
So, if SRI is to sustain its ambition of becoming a dominant mainstream investment strategy, it must necessarily do more to forestall this type of financial and
wider economic risk. Among many other things, the financial crisis has thus
also raised some questions as to the effectiveness and legitimacy of SRI as it is
practised today. The approach we are going to present below seeks to take up
this challenge.
How to survive the next crisis
2. From extra-financial
to financial
sustainability
ESG ratings have become almost a commodity
Information and ratings on Environmental, Social and Governance (ESG)
aspects of companies have become almost a commodity on the market.
The boost in sustainable investment that took place in the second half of the
1990s and a decade of consolidation (in terms of methods, but more recently,
also in terms of research providers) have led to a situation where interested
investors and asset managers can get easy access to sustainability-related
information on companies, either by sourcing in from specialised units at
sell-side brokers, a host of independent research providers and, increasingly,
via standard financial data providers such as Bloomberg, Reuters and MSCI.
The current ESG research is still predominantly ‘qualitative’ in its nature,
assessing companies’ policies and management systems, etc., but more
quantitative approaches (‘carbon footprinting’) have lately been gaining traction.
Conventional ESG protects well against reputation risks...
ESG ratings inform investors whether companies are well prepared to face
future sustainability challenges. As such, a high ESG rating is usually a good
indication of a generally well-managed company that is less likely to get
embroiled in major controversies or to incur substantial regulatory or operational risks. Such companies are, therefore, also less likely to compromise the
reputation of the investor or the asset manager. The application of appropriate
ESG filters can provide investors with a reasonable degree of assurance that
the companies held in the portfolio satisfy certain minimum sustainability
criteria. And, to follow up on what we have pointed out above, such a filter,
if well designed, can also help to promote best practices that ultimately reduce
or mitigate environmental and social externalities.
...but not against major downturns or wider economic externalities
As mentioned above, however, there is no empirical evidence that combining
companies with a higher ESG rating in a portfolio can on its own protect
investors from a major market downturn. What is also largely missing in
conventional ESG frameworks is ‘the bigger picture’, something that relates
SRI to the broader concept of financial and economic stability.
What indicators and
factors should be
used to identify
the companies that
contribute most to
economic stability?
Introduction/Motivation
In this respect, the financial crisis has acted as an eye-opener for us. There is
in our view a whole new field that sustainable investment has yet to explore,
namely what indicators and factors should be used to identify companies
that by virtue of their own higher resilience to market shocks not only ensure
their own economic survival but also contribute to the stability of the entire
economic system. Our goal must be to build truly sustainable portfolios that
can be more of a safe haven to investors in difficult times while promoting
companies that are more likely to limit or mitigate wider negative economic
externalities through their own higher stability.
From extra-financial to financial sustainability
Results
Discussion & Conclusion
Summary
5
The quest for ‘financial sustainability’
For this purpose we looked into a large number of fundamental financial
company factors thought to provide benefits and mitigate risks to companies
and their investors as well as for the broader society and the economic system.
We then tested their historical performance and retained only those candidates
that had been associated with robust and superior risk-adjusted returns in the
past. We would circumscribe this doubly favourable characteristic as ‘financial
sustainability’.
Our research into financial sustainability area is ongoing and there is no – and
probably never will be – definite and exhaustive list of the factors we work
with. Rather, we will keep on searching and testing potential candidates with
a view to improving our financial sustainability model. Nevertheless, to give
the reader a better and more concrete idea of what our improved approach is
all about, we would like to highlight two fundamental sustainability factors
in greater detail below.
The field of financial
sustainability is still
unchartered territory
and we have just
started to explore it
and harness its
potential for our
investment process.
Leverage is unsustainable and drives volatility
Although we are far from a consensus as to what exactly triggered the financial
crisis, it is probably fair to say that excessive leverage, particularly within the
financial industry, is one of the prime suspects. Moreover, high leverage also
automatically makes companies’ earnings, and therefore their stocks, more
volatile. This relation, referred to as ‘leverage effect’, can be particularly strong
in a recessional environment. Excessive leverage is not only a big risk for the
companies themselves but can – as we all witnessed – also jeopardise financial
markets and ultimately the economy as a whole. Low or moderate leverage is
therefore a good candidate of a fundamental company factor likely to increase
financial sustainability across the system, as it is not only relevant from a
company’s individual risk perspective, but also from a broader societal point
of view. Moreover, what makes leverage particularly interesting as an input
for our sustainability model is the fact that lower leverage has also been
documented in the financial literature as earning abnormal returns 5.
5
6
See, for example: Fama and French,
“The Cross-Section of Expected Stock Returns”,
Journal of Finance 47, 1992
High and volatile asset growth is unsustainable
Total asset growth captures the aggregate growth of a firm. Stable asset growth
can usually be associated with a business model focused on steady and organic
growth. Companies seeking growth through merger and acquisitions are very
likely to run into trouble at some point in the future. Buying external growth is
foremost driven by a desire to exploit synergies, i.e. streamlining and eliminating ‘redundant’ structures that often lead to job cuts or other frictions, tying up
precious management capacity that could better be invested elsewhere. High
and very high asset growth rates are therefore not compatible with the ideal
of sustainable growth. They are rather an indicator for higher vulnerability and
a harbinger of instability in times of market turmoil.
How to survive the next crisis
Most interestingly, investors seem to agree with this view. For although the
exact mechanisms are still debated, a growing body of empirical evidence
suggests that corporate events associated with asset expansion (i.e., acquisitions, public equity offerings, public debt offerings, and bank loan initiations)
tend to be followed by periods of abnormally low returns 6. Obviously, we have
here yet another systems-stabilising factor associated with higher risk-adjusted
returns.
6
See, for example: Cooper et al.: “Asset Growth
and the Cross-Section of Stock Returns”,
Journal of Finance 68, 2008
Introduction/Motivation
Defining and combining factor portfolios
Let these examples of financial sustainability factors suffice for the moment
and let us take a look at what happens when those factors are combined into
a diversified sustainable portfolio. We did this by constructing a number of
factor portfolios, each one expressing a particular financial sustainability factor,
and then combined those portfolios in an appropriate way with a view to
delivering the best expected risk-return profile for investors.
From extra-financial to financial sustainability
Results
Discussion & Conclusion
Summary
7
3. Results
Testing our hypothesis
In order to test whether the proposed financial sustainability approach is
actually able to deliver the desired results, we simulated the performance of
several portfolios constructed in this way for the major core equity markets
from January 1999 to the end of November 2010. The period chosen includes
the final phase and the burst of the dotcom bubble, the protracted bull market
phase from 2003 to 2007 as well as, most interestingly perhaps, the financial
crisis and its aftermath. As such, the observation period can certainly aspire
to cover widely differing, sometimes extreme, stock market environments.
Global and regional sustainability portfolios
Setting out from an SRI constrained investment universe we constructed
and then calculated the cumulative relative performance of a global and three
regional sustainable core equity portfolios (World Developed, Europe, North
America, and Pacific) against the corresponding MSCI benchmark. The sustainability factor portfolios were calculated on a half-yearly basis corresponding
to a semi-annual rebalancing 7. The sustainability portfolios we tested represent
broadly diversified equity portfolios with a tracking error of approximately
3 per cent over their underlying MSCI benchmarks.
RELATIVE PERFORMANCE OF SUSTAINABLE PORTFOLIOS (1999-2010)
20%
15%
MSCI World, monthly return
10%
5%
0%
-5%
-10%
-15%
Sustainable Portfolios
World
North America
Europe
Pacific
-20%
01.1999
01.2000 01.2001 01.2002 01.2003 01.2004 01.2005 01.2006 01.2007 01.2008 01.2009 01.2010
Fig.1. Sustainability portfolios for the major core equity markets versus their corresponding conventional
MSCI benchmarks. The bars represent the monthly total returns of the MSCI World.
All portfolios showed
a stunning outperformance during the peak
of the financial crisis
and in the meltdown
after the Lehman
collapse
7
8
Only information available, known and published
at the time of each rebalancing was used. As such,
we avoided falling prey to hindsight bias.
Sustainable portfolios outperformed except in the steepest rebounds
The results of our simulation are displayed in Fig.1 above. All three regional
sustainability portfolios as well as the sustainably optimised global portfolio
outperformed their corresponding benchmark over the period by a comfortable
margin. With the exception of the North American portfolio, which lost out
somewhat, the sustainably optimised portfolios performed in line with the
broad market during the final stage of the dotcom boom. All four portfolios
started to outperform their respective benchmarks clearly once the bubble
burst. Interestingly, the sustainably optimised portfolios continued to add
value during the ensuing bull market until 2005 when the outperformance
flattened out. From 2005 until the onset of the financial crisis the portfolio
again performed in line with the market. All portfolios showed a stunning
outperformance during the peak of the financial crisis and in the meltdown
after the Lehman collapse. The sustainable portfolios lost out markedly
How to survive the next crisis
(in relative terms), however, during the particularly strong rebound in spring
2009, but they yielded only a part of the outperformance they had accumulated
before, thus weathering the crisis much better than the broad market. Since
then, the three sustainably optimised regional portfolios seem to have aligned
themselves again on a slight but steady upward trend, whereas the aggregate
global sustainability portfolio performed more or less in line with the MSCI
World.
Sustainable portfolios are much more than just ‘crisis-proof’
What is particularly noteworthy in our view is the observed pattern of outperformance. Less so, because of its protective behaviour in the heat of the crisis.
Intuitively, one would have expected – or at least hoped – that a sustainable
portfolio geared towards lower extra-financial and financial risks would
eventually show higher resistance to market shocks. But it comes as a pleasant
surprise that the sustainably optimised portfolios kept adding value in the
protracted bull market that followed the bust of the dotcom bubble and led
all the way up until the onset of the financial crisis.
Our new concept
of financial sustainability holds the
promise of higher
returns for less risk...
And yet, we should probably not be too surprised, either. We have to remember
that when we identified our fundamental sustainability factors, we were explicitly looking for candidates with an abnormal return pattern, i.e. factors which
historically have been found to deliver a higher performance than predicted by
financial theory. As such, our results can be interpreted as a confirmation of the
academic findings quoted in chapter 2 above.
Whereas generations of investors have learnt and internalised that financial
outperformance is only to be had for higher risk, the results or our simulation
suggest otherwise, at least for the time period we tested. It looks as though,
in a sustainability context, more is indeed to be had for less. The new concept
of financial sustainability seems to hold the promise for reaping extra returns
all by investing in a less risky (both extra-financially and financially speaking)
and therefore more sustainable way.
Introduction/Motivation
From extra-financial to financial sustainability
Results
Discussion & Conclusion
Summary
9
4. Discussion
& Conclusion
Results confirm our hypothesis
We set out to make SRI portfolios not only less risky in ESG terms but also
more resilient in conventional financial terms by combining the concept of
extra-financial sustainability with a new and innovative approach we suggest
should be called financial sustainability. The latter is based on fundamental
company factors that we believe are risk-mitigating, return-enhancing and
likely to reduce negative externalities on the financial and the economic system.
The results of our historical simulation presented in the previous section
confirm our hypothesis that enlarging the set of extra-financial criteria by
fundamental financial factors and constructing optimised portfolios based
on the latter can indeed provide investors with more stable portfolios whilst
adding financial value over a standard benchmark.
Financial sustainability is the better ‘materiality’
Unlike what we would call the ‘ESG materialists’ who look for financial outperformance in ESG indicators, we suggest taking exactly the opposite approach:
searching for sustainability in fundamental financial indicators. As we have
repeatedly argued in the past 8, the concept of ‘ESG materiality’ is incomplete
at best and outright flawed at worst. According to the ‘ESG materialists’, one
should exclusively look at those ESG criteria that impact on the bottom line
of companies. But every self-respecting conventional financial analyst already
does take into account all factors – financial, extra-financial or whatever their
origin – that have an impact on the bottom line of his investment (that is his
job, after all). Therefore, the search for ESG materiality does actually do little in
terms of adding financial value but a lot in terms of watering down the original
concept of Socially Responsible Investment, which was above all about aligning
one’s investment decisions with one’s values while trying to promote sustainable business practices.
8
Back to Sustainable Development – Or why the
ESG materiality debate misses the point... Viewpoint.
Pictet Asset Management 2006
10
A true SRI filter must take care of externalities
Financial analysts are good at factoring in what is financially material to
the companies they cover, but they can usually not be expected to look at the
broader environmental, social and government context of their investments.
More to the point, they do not look at externalities – either positive or negative –
because the very definition of the concept says that externalities do not show up
on companies’ accounts. This is the realm of SRI or extra-financial research.
A credible SRI filter must ensure in the first place that the investment universe
does not contain companies who act irresponsibly, contribute to serious
environmental degradation, social harm or undermine the trust of financial
markets through bad corporate governance standards. As a consequence,
the most important role of the extra-financial filter must be to eliminate those
companies that pose potentially unacceptable sustainability risks to investors
and keep those that seem better equipped to meet the great challenges of the
future.
How to survive the next crisis
Extra-financial screening is a necessary, but not a sufficient condition
A meaningful extra-financial filter will therefore always remain a cornerstone
of any credible sustainable investment approach. It strikes us as a necessary
but nevertheless not a sufficient condition for a truly sustainable investment
strategy. More is needed. Adding financial sustainability to the equation
therefore neither dilutes nor perverts the initial sustainability of the restricted
investment universe. On the contrary. It adds another, widely overlooked
dimension to traditional ESG analysis – namely negative externalities on the
financial markets and the economy – whilst at the same time allowing for
the construction of investment portfolios that are both more resilient to shocks
and financially attractive.
Introduction/Motivation
From extra-financial to financial sustainability
Results
Discussion & Conclusion
Summary
11
5. Summary
We suggest looking
for sustainability
in financial
fundamentals
Existing Socially Responsible Investment (SRI) approaches did not provide
investors with a better downside protection during the financial crisis, nor did
they pay enough attention to some particularly negative financial and economic
externalities that compounded its gravity. Eliminating environmental, social
and governance (ESG) risks still strikes us as a necessary but not a sufficient
condition on its own, for a truly sustainable investment strategy.
In order for SRI to survive and become the investment strategy of first choice
beyond its present niche, it has to provide both sustainability and higher riskadjusted returns in the future. Whereas the so-called ‘ESG materialists’ continue
to look for financial performance in extra-financial criteria – thereby wilfully
neglecting negative and potentially destabilising externalities – we suggest
doing exactly the opposite and searching for sustainability in companies’
financial fundamentals. We achieve this by identifying and testing those
factors that make companies more stable over time, more resilient to market
downturns, and thus contribute to the stabilisation of financial markets and
the entire economy. We focus on those financial sustainability factors with
superior historical risk-return characteristics. We call this approach ‘financial
sustainability’.
We go on to construct portfolios that optimally express those financial sustainability factors and combine these ‘factor portfolios’ into one global and three
regional sustainably enhanced core equity portfolios. We test the relative
performance of the sustainable portfolios against their respective conventional
MSCI benchmarks over the last decade. The results are encouraging and
confirm our hypothesis that optimising screened portfolios from a financial
sustainability point of view can make them more resilient to drawdowns and
tends to outperform in most environments except in the most vigorous market
recoveries.
The results suggest
that combining extrafinancial and financial
sustainability could
eventually pave the
way for a much wider
adoption of sustainable
investment strategies.
For too long already, SRI investors have been given the run-around, having
been promised, explicitly or implicitly, that extra-financial research alone
could shield them from market adversities. An assertion which is not borne
out by facts. Something else is needed. To tilt ESG-screened portfolios towards
more financial sustainability opens up an interesting perspective. The promise
of lower risk and higher returns (both in the extra-financial and financial
dimension) finally seems to be at arm’s length.
Authors:
Christoph Butz
Laurent Nguyen
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12
How to survive the next crisis
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