July-August 2015

INSIDE VIEW: Sustainability moves into the fast lane

FastOmar Selim of Arabesque Partners explains the shift of socially responsible investing into the mainstream. Sustainability has emerged as a financial megatrend. Not only has it changed how corporations operate, but increasingly how investors seek returns too.  With ever greater environmental, social and governance (ESG) information becoming available, socially responsible investing – SRI – is entering exciting new territory. Evidence is growing that there is strong value in these new sources of non-financial information to improve risk-adjusted returns, and people are taking note.  A survey of 60 major institutional investors recently released by PwC revealed that 97% expected responsible investment to increase in importance over the next two years.  In 2014, Eurosif, the European sustainable investment forum, published a report revealing that assets managed under sustainable principles are growing at a faster rate than the broader European asset management sector.  As we stand in 2015, more than one out of every six dollars under professional asset management in the US is in sustainable investment, while global SRI assets stand at over $21 trillion (€19.1 trillion). This equates to more than 30% of all global assets under management.  Sustainable investment, long viewed as a niche sub-sector within the investment world, is moving into the fast lane.   This in part has been facilitated by a growing number of non-financial disclosure and reporting initiatives, including the Global Reporting Initiative and the Sustainability Accounting Standards Board, among others. The result has been a strong global increase in recent years in the number of countries disclosing non-financial information.  The fact that more than 70% of S&P 500 companies reported on sustainability in 2013, a marked increase on 2011’s figure of 20%, demonstrates a sharp shift towards ESG disclosure.  As a result, brokerage research desks are now also covering non-financial information in greater depth. UBS, for example, has developed a global ESG analyser to help identify the most prominent ESG themes and global sector exposures.  Many more brokers are now increasing their SRI efforts, demonstrated by the growing number of analysts in SRI  teams, according to the most recent Extel/UKSIF SRI and Sustainability Survey.  It is clear, therefore, that SRI is on an upward trajectory on a global scale. But how do we quantify the level of value that ESG information can add to the investment process? While the potential for further growth in SRI in the years ahead is huge, it is hinged upon the ability of proving that ESG can deliver superior returns to the investor.  In a major meta-study released by Arabesque Partners in collaboration with the University of Oxford in September 2014, it was found that 80% of past research identified a positive relationship between sustainability practices and investment performance. Sound sustainability standards were also found to lower a company’s cost of capital according to 90% of the literature examined, while 88% of studies linked good corporate behavior with better operational performance.  Taking this research further, and to understand the impact of sustainability on portfolio performance, let’s examine three specific but simple strategies on a universe of global stocks.  l Worst-in-class exclusion: Excludes companies that are in the bottom 25% of ESG performers in their respective industry. l ESG tilt: Doubles the portfolio weight of the top 25% ESG performers per industry and halves that of the bottom 25%. l ESG momentum: Invests in a portfolio of stocks that have witnessed two consecutive improvements in their ESG performance (as calculated on a relative basis per industry) over the past two quarters. In this approach, we measure sustainability performance as a percentile rank based on ESG scores from Sustainalytics. The sample data is taken from 2011 to 2015 (year to date), with portfolios rebalanced quarterly based on these three strategies.  All three ESG strategies outperformed the MSCI All Country World Index benchmark. A simple exclusion of the 25% ‘worst in class’ companies, based on an overall ESG score, leads to an outperformance of 114 basis points per year against the benchmark. Tilting the portfolio towards ‘more sustainable companies’, rather than excluding ‘less sustainable’ firms, results in 94 basis points of outperformance annually, while a portfolio factoring only ESG momentum achieves outperformance of 2.72% annually against the index. This demonstrates how sustainability can fuel return.   Such quantitative strategies rely of course upon the disclosure and accuracy of non-financial information. Traditionally, this has posed a challenge and it is only in more recent years that a new era of corporate reporting has been ushered in, bringing improved, quality accounting infrastructure to material sustainability factors.  In addition to this, we are also seeing innovation in how ESG event-driven analysis or ‘news’ can be used as a valuable source of information in the investment process. To be specific, the analysis of online media sources can provide investors with a different perspective on a firm’s activities by examining what a company does rather than says.  While ESG event-driven analysis is still an emerging area of academic research, initial studies highlight the identification of supply chain risks to predict higher stock volatility and share price underperformance.  One recent example is McDonald’s Holding Co Japan. For years, the company had a history of stable cash flows, exhibiting low stock volatility and scoring relatively well on traditional ESG policy-based metrics. But in 2015, after a series of high-profile food safety concerns, supply chain problems and labour disputes, the company reported its first  annual operating loss since  going public.  Research therefore suggests that ESG news can provide a complementary source of information to identify ‘red flags’ in companies when used in combination with more traditional metrics. With more non-financial information becoming available in increasingly standardised ways, new opportunities are therefore opening up in the investment world. Indeed, we can see from the performance analysis of even simple ESG strategies – as demonstrated here – that non-financial data can improve portfolio returns. Furthermore, new and advanced ESG analytical techniques will only become more effective in the years ahead in sifting ‘greenwashing’ from real, positive corporate sustainability.   As evidence grows of the significant value that ever-increasing non-financial information can bring to the investment process, it is surely therefore only in the best interests of asset owners and managers to integrate ESG information to achieve higher risk-adjusted returns.  In doing so, we will increasingly replace the question ‘how much return?’ with ‘how much sustainable return?’, evolving from stockholders to stakeholders in the process.  Omar Selim is chief executive officer of ESG quant fund. manager Arabesque Partners ©2015 funds europe

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