Harnessing the power of ESG risk premia in systematic investing

Jessica Phalafala, Quantitative Analyst, Prescient Investment Management

Socially responsible investing (SRI) has undergone a profound evolution since its origins in colonial America, where religious groups abstained from investing their endowment funds into anything associated with the slave trade. Centuries later, it transformed into mutual funds screening out investments that were directly or indirectly associated with gambling, alcohol and tobacco.

SRI was further used as a tool to express the moral values of institutional investors and their support for historical movements. As a case in point, during the apartheid regime in South Africa, many global mutual funds screened out companies that were engaging in business in the country.

At the dawn of the 21st century came a heightened global awareness of the myriad of acute challenges we face as a planet, ranging from climate change, socio-economic inequalities, and the rise of unjust and exploitative institutions. This heightened the awareness of the need to introduce responsible investing methodologies that were significantly more extensive and far-reaching than the traditional screening approach.

The term Environmental, Social and Governance (ESG) investing was first coined by the United Nations Global Compact in 2004 and involved the systematic integration of these factors into the investment processes of financial institutions. ESG investing has since gathered significant momentum and continues to gain traction in line with the fundamental shift in investor perceptions as they recognise the material impact ESG factors can have on investment returns.

The United Nations-supported Principles for Responsible Investment (UNPRI) were launched in 2006, with just over 60 signatories representing $6.5-trillion in assets under management. Support for the UNPRI has since exploded, and now it has more than 3 000 signatories, representing $103.4-trillion in managed assets, all of whom are committed to integrating ESG factors into their respective investment processes.

This remarkable growth in ESG investing can be ascribed to the growing evidence that ESG-related performance may be a proxy for company productivity and stability, thereby providing an additional source of excess returns. Risk premia strategies have been used for decades in systematic investing as a method for harvesting excess returns.

This is achieved by investing in factors that have been proven academically and in practice to provide the investor with a positive payoff for undertaking the risk associated with each factor. Commonly used risk premia include the value risk premium, which is the excess return derived from companies that are trading at a low-price relative to their fundamental value; the momentum risk premium, which favours stocks that have displayed a sustained positive return trajectory over a given period; and the market risk premium, which is the differential between the market yield and the risk-free rate of return.

These factors have all been proven to yield higher long-term risk-adjusted returns. The overwhelming evidence confirms that using ESG factors in the portfolio construction and security selection process based on factor analysis and risk premia strategies allows investors to yield additional risk-adjusted returns.

The logic that value-creating ESG-related practices contribute to company outperformance upholds the thesis. For instance, a well-managed company that adheres to environmental and social regulations is less likely to face litigation, the higher costs associated with the management and disposal of hazardous waste and elevated employee injury rates.

Therefore, ESG factors may provide better insight into the probability distribution of company returns in the same way as the traditional risk premia incorporated in classical asset pricing frameworks. Also, ESG factors are strong candidates for inclusion in long-term factor investing. They display strong explanatory power over a wide range of securities, offer a positive payoff over reasonably long horizons, have a significantly low correlation with other factors and, above all, they make intuitive and economic sense.

In identifying ESG factors as risk premia, the systematic investor needs to move beyond traditional screening methodologies and policy implementation towards a rules-based, scalable and measurable ESG integration strategy. To do so requires practical, quantifiable metrics  that can be readily integrated into an existing investment process, together with other strategies to construct a well-diversified portfolio.

To this end, we have developed the Prescient ESG Scorecard which is an in-house risk analysis tool designed to evaluate and measure the ESG risks and opportunities associated with the credit and equity counterparties in which we invest. It is a data-driven and systematic scorecard that rates companies relative to their sector-specific peers while accounting for industry materiality and market cap biases. We employ over 60 metrics to gain granular insights into the proficiency of the ESG practices of the underlying counterparties.

Each of the metrics is conscientiously identified and selected to address a broad range of globally recognised material ESG themes. These themes include board and workforce diversity, board structure, water usage, greenhouse gas emissions and the safety of employees, to name a few. A combination of extensive ESG research, active engagement with our investees and this cross-sectional scoring tool has significantly enhanced our ability to integrate ESG into our investment process alongside the traditional risk premia we consider. It also enables us to interrogate practices that historically eluded systematic investors.

The last decade has seen ESG find a permanent place in everyday investing. Its rise in popularity has shown no signs of slowing down, with Bank of America forecasting a “tsunami of assets”, as much as $20-trillion, flowing into ESG funds in the US alone over the next two decades.

At Prescient, we believe it is  our responsibility to preserve our clients’ capital by deploying it in a manner that promotes sustainability and delivers on our goal to achieve superior risk- adjusted returns. We accomplish these two goals by managing absolute and relative downside financial risk, as well as non- financial operating risk. We consider ourselves well-equipped to deliver on these twin objectives given our comprehensive responsible investing philosophy and approach, as well as our expertise as a seasoned systematic investor.

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Taking stock of Covid-19 through a sustainability lens

If you are reading this, you are well on your way towards surviving one of the most cataclysmic events of our lifetime; one that is forever going to reshape the way we view the world and drive home the importance of prioritising sustainability and all it entails during the years ahead.

The coronavirus, which originated in a wet market in Wuhan, China, in December 2019, has since been declared a global pandemic that has spread across the planet through international travel and global supply chains. At the time of writing, the number of cases worldwide was inching towards the 54-million mark. Additionally, the effects of the virus have reverberated through global financial markets and economies, resulting in the greatest recession since World War II.

The pandemic has also brought to bear the severity of socio-economic inequalities, risks introduced by our unsustainable systems as well as the materiality of fat-tail events. In so doing, it has provided us with an opportunity to redefine a new normal and introduce structural shifts that will help us work towards a sustainable future for all.

Many countries instituted national lockdowns at an early stage in the pandemic, which is a classic example of a suppression approach to pandemic management. The logic underpinning this methodology is to introduce social distancing to entire populations and minimise the number of additional infections reproduced by each confirmed case, thereby slowing the spread. This, ceteris paribus, is a highly effective public health risk management plan. However, in reality all other things are not, in fact, equal. Thus, the coronavirus has brought crucial attention to the social element of environmental, social and governance (ESG) issues.

National lockdowns entail the suspension of economic activity, which results in loss of income and employment, pushing the vulnerable segments of society, already on the precipice of poverty, into a state of destitution. Also, countries encumbered by acute socio-economic inequalities, like South Africa, have had to face the reality that large segments of their populations living in high population density areas and with inadequate access to clean water and sanitation would face a higher risk of exposure to Covid-19. The reality of the plethora of social risks has since powered the rollout of unprecedented global fiscal stimulus packages to soften the adverse economic effects of the pandemic.

Although these packages have provided the buoyancy required to see us through the immediate challenges, a fundamental shift in the discourse surrounding the risks fragile economic structures pose is translating into the development of a far more robust and well-defined path towards a sustainable future.

Consequently, sustainable investing will be a vital component of a post-pandemic recovery. For instance, there has been an increase in the global issuance of social and sustainability bonds over the past five years. New issuances in response to Covid-19 are also coming to market. A guidance note has been published by the International Capital Markets Association (ICMA) to provide a benchmark for the structuring and reporting standards associated with the new Covid-19 social bonds.

Domestically, the South African Minister of Finance announced plans to amend Regulation 28 of the Pension Funds Act to improve the ease with which retirement funds can finance infrastructure projects to help kickstart economic development.

The establishment of a robust regulatory framework and the dramatic increase in the need for social intervention worldwide will dramatically improve the level of interest in sustainability bonds and help reshape the economy of the future.

Companies adapting to change

Specific sectors and individual firms have been impacted in varying ways by the pandemic. When governments instituted lockdown laws, the spotlight turned to company governance practices and how executives would navigate the crisis.

Corporate boards faced scrutiny from various stakeholder groups that challenged the shareholder-centric model of governance, thereby making the board decision-making process much more multi-faceted. Companies became more cognisant of the central role they play in maintaining the socio-economic well-being of society through sustained value-creation. They also recognised how a well-functioning society puts them in a better position to meet their key performance indicator targets.

As a result, many boards decided to suspend or reduce their dividends and bonuses due to uncertainty regarding the scope and duration of the crisis. From an environmental perspective, working from home policies shed light on the environmental impact of commuting workforces. According to the International Energy Agency, a record drop in emissions is expected for 2020, with a projected 7% decline in energy-related CO2 emissions relative to 2019. Cities across the world have experienced lower smog levels, reduced water pollution and restored biodiversity highlighting the benefits of working remotely.

As such, many companies, like Microsoft, have implemented these policies permanently. Research also shows that infectious disease transmission is precipitated by rising temperatures, loss of biodiversity and other elements of climate change. By acknowledging this interconnectedness, global corporations are now playing a pivotal role in mitigating climate change risks.

Another equally crucial indirect consequence of the pandemic is the shift in focus to the social component of the traditional business model. Corporate culture measures such as employee health and safety and labour practices, including paid sick leave, have become priority areas and subject to intense public scrutiny.

Furthermore, severe supply challenges have also highlighted the risks of globalisation, and many companies have since amended their supply chain management processes to better diversify suppliers and reshore production. These social developments will not only improve working conditions but foster job creation and enterprise development.

Investor awareness on the rise

In light of the pandemic and growing public awareness of the climate crisis, investors across the world are shifting from a morally agnostic investment approach to one that aligns with their ethical concerns. This is evidenced in budding investor appetite for sustainable products, which has resulted in record-breaking flows into ESG funds in 2020.

Companies with strong ESG profiles have shown resilience in this time of crisis by staging a strong recovery post the March market lows.

This has prompted investors to rethink the impact ESG considerations may have on their investment returns. As supporting evidence, the MSCI World ESG Leaders Index has delivered returns in line with the MSCI World Index within a tight tracking error, other than its marginal outperformance in the wake of the March 2020 crash. This is a comforting return profile for the passive but ethically driven, investor.

Sustainable practices, such as strong incident risk management, fair labour practices, stakeholder-conscious boards, and clear decarbonisation pathways, have proven to be factors that drive long-term sustainable returns. To this end, we should witness an acceleration in the incorporation of ESG considerations into traditional valuation and risk models.

Forging a path forward

The turbulence caused by the pandemic and its indirect consequences has emphasised the need for global social change, multi-stakeholder centric business models, and international cooperation on public health and climate change considerations. This provides us with the carte blanche to rebuild a sustainable future for all and a resilient global financial ecosystem. The question is, which side of history do you, as an investor, want to be on?

Jessica Phalafala, Fixed Income Quantitative Analyst, Prescient Investment Management
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ESG: vital for robust investment strategies

Growing investor awareness and the willingness to engage in issues related to sustainability, combined with the increasingly vivid positive relationship between sustainable practices and financial performance, have cemented ESG considerations as an integral part of any robust investment strategy.

According to data from Morningstar Direct, more than $10 billion of assets in the US have been directed towards investing in sustainable funds during the first quarter of 2020 alone. These record-setting levels of flows underscore the growing significance of Environmental, Social and Governance (ESG) considerations when making investment decisions. Growing investor awareness and the willingness to engage in issues related to sustainability, combined with the increasingly vivid positive relationship between sustainable practices and financial performance, have cemented ESG considerations as an integral part of any robust investment strategy.

At Prescient Investment Management, our investment philosophy is capital preservation and the pragmatic management of funds. We systematically take on only those risks that have proven to deliver commensurate returns over time. We adopt a holistic and integrated approach to our investment considerations, ensuring that we deploy our clients’ capital in a manner that promotes sustainability.

We have embedded ESG integration into our investment process; our product development, the suite of ESG-centric products we offer, and our corporate culture. Prescient follow rules-based security selection and portfolio construction methods that are designed to capture excess returns by investing in those factors (sometimes referred to as smart-beta) that are proven to provide positive payoffs in the long term. Common examples of such factors are Value, Low Volatility, Quality and Momentum.

The recent proliferation of ESG as an undeniable driver of return. the consistent debunking of the historically held perception of an inverse relationship between financial returns and sustainability has made it clear that ESG can also be added to the list. We have developed a systematic and data-driven in-house ESG risk-analysis tool that evaluates and scores listed securities based on their ESG risks and opportunities.

The Prescient ESG scorecard consists of three pillars, namely: Environmental, Social and Governance. It considers material themes such as (but not limited to) diversity, board structure, emissions and energy consumption by appropriately selecting and categorising over sixty underlying metrics. This fully automated and rules-based scorecard accounts for industry materiality and company size biases and provides a granular and in-depth measure of the proficiency of the governance practices as well as the environmental and social impact of our holdings.

At a product development level, the Prescient Clean Energy and Infrastructure Debt Fund has been specifically designed to encompass our sustainable investing philosophy and impactfully deliver on our ESG targets. It participates directly at the project level of the Renewable Energy Independent Power Producer Procurement (REIPPP) Programme. The Fund seeks to invest in clean energy and other infrastructure projects that will have a positive social and environmental impact. The target is to build a well-diversified portfolio of infrastructure investments that will improve the sustainability of our energy supply and provide the infrastructure that is vital for the development of South Africa.

We strive to uphold and incorporate the same ESG values and principles that frame our product development and investment process at our corporate level. As South Africa’s largest black-empowered asset manager, we deem transformation and Broad-Based Black Economic Empowerment to be paramount in achieving economic inclusion and a sustainable business topography in the country. We take sustainability considerations into account when allocating brokerage services, for example, as well as in any of our enterprise development undertakings.

We remain sensitive to the fact that our country is encumbered by an array of socio-economic challenges, as is reflected by our high levels of inequality and unemployment. As a corporate response, the Prescient Foundation embarks on various projects and social upliftment initiatives to address the social issues that face many South Africans.

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