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Sustainable Investing (ESG, SRI) - YouTube
Channel: Ben Felix
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- Individuals and large institutions alike
[2]
are allocating more of their dollars
[4]
to investment strategies
that meet some level
[7]
of environmental, social
and governance criteria.
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This is commonly referred to
as responsible, sustainable
[13]
or green investing.
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I'll use sustainable to
describe it in this video.
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According to the 2018 global
sustainable investment review,
[21]
as of the start of 2018,
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more than 25% of US domiciled
assets under management
[27]
were invested in sustainable strategies.
[29]
In Canada, it is just
over 50% at 2.1 trillion
[33]
in Canadian dollar terms,
[34]
that's up 42% since 2016
[37]
BlackRock, one of the world's
largest asset managers
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recently committed to
making sustainability
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a key part of their investment process.
[45]
This growth in sustainable investing
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is good news
[48]
to the extent that sustainable investing
[49]
leads to positive social impact,
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but it also has some
important implications
[54]
for expected investment outcomes.
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I'm Ben Felix Portfolio
Manager at PWL capital.
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In this episode of common sense investing,
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I'm going to tell you how you
can align your investments
[63]
with your views and values.
[64]
But it's probably going to cost you.
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(upbeat music)
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The two most common types
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of sustainable investment strategies
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are negative screening
and ESG integration.
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Negative screening
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eliminates certain sectors,
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companies or practices from a portfolio.
[82]
ESG integration is more of a re-weighting.
[84]
Instead of completely
eliminating industries,
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an integration strategy
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will underweight companies
with lower ESG scores
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and increase the weight of companies
[92]
with higher ESG scores.
[94]
There are index funds that
employ both of these strategies
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often in combination with each other.
[99]
Having a sustainable portfolio sounds
[101]
like a really good idea
[102]
and it might feel even
better than it sounds.
[105]
However, I think that you need to consider
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two equally important factors
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in deciding to implement a
sustainable investment strategy.
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The first factor is the impact
on your expected returns.
[114]
And the second is the extent
to which the investment
[117]
actually reflects your views and values.
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These two considerations
need to be assessed jointly.
[123]
If a sustainable portfolio
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has slightly lower expected returns,
[127]
but is a perfect reflection
of your views and values,
[130]
you may be willing to
accept the trade off.
[132]
But accepting the lower expected returns
[134]
of a sustainable portfolio
[135]
that does not reflect your
specific set of use and values,
[138]
might not be a trade-off
[139]
that most investors should consider.
[141]
Let's start with the impact
[142]
of socially responsible
investing on unexpected returns.
[146]
The effect of ESG scores
[147]
on stock returns was
examined in the 2019 paper
[150]
by Rocco Ciciretti, Ambrogio
Dalo and Lehmertjan Dam.
[155]
They controlled for common risk factors
[157]
and looked at a global sample
[158]
of 5,972 firms for the
period 2004 through 2018.
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They found that companies
with higher ESG scores
[166]
tended to deliver lower average returns
[169]
than companies with lower ESG scores.
[171]
They found a statistically
significant negative premium
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for the ESG characteristic
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in a traditional Fama French
five factor regression
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a six factor regression,
including momentum
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and a seven factor regression,
including an ESG risk factor.
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They found that a one
standard deviation decrease
[187]
in the ESG score is associated
with a 0.13% increase
[191]
in monthly expected returns.
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Put simply,
[194]
controlling for exposure
[195]
to known drivers of returns
[197]
companies with higher ESG scores
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tend to do worse
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than companies with lower ESG scores.
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The authors considered
two possible explanations
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for this observation,
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both grounded in economic theory
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ESG characteristics reflect
investor preferences
[211]
or ESG characteristics
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are captured by some
underlying ESG risk factor.
[217]
Based on the previously
mentioned factor regressions,
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they found it much more likely
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that it is an investor preference
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that drives a negative ESG premium.
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Investors may be willing
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to accept lower expected returns
[229]
simply because they do not want to invest
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in certain types of firms.
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This is not a risk premium
[235]
but an effective investor tastes.
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That word tastes is important.
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In their 2007 paper,
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disagreements, tastes and
asset prices, Eugene Fama,
[245]
and Ken French explained
[246]
that investors may hold an asset
[248]
partially as a consumption good,
[250]
regardless of its expected return profile.
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If they have a taste for that asset.
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If enough wealth is controlled
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by investors with specific tastes
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such as the case of sustainable investors,
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the effect on prices could be meaningful.
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Another way to think about this
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is that investors with a taste
for sustainable investments
[268]
require higher expected returns
[271]
to be convinced to invest
in an unsustainable company.
[274]
This drives up the expected returns
[276]
of unsustainable companies.
[278]
They're also willing
[279]
to accept lower expected returns
[281]
to invest in sustainable companies.
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This drives down the expected return
[285]
of sustainable companies.
[286]
In a 2019 study,
[287]
Olivia David Zerbib,
[289]
developed an asset pricing model
[291]
including premiums for ESG
exclusion and investor tastes.
[295]
The premiums for exclusion
[297]
are related to the
increased risk of stocks
[299]
that are neglected by
sustainable investors.
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The premium for investor
tastes is related to the cost
[304]
of externalities
[305]
that sustainable investors internalize
[307]
to maximize their welfare
[309]
instead of the market
value of their investments.
[312]
Using this model,
[313]
Zerbib analyze US stock
data between 2000 and 2018.
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He found an exclusion
effect of 2.5% per year
[320]
and a taste effect of 1.5% per year.
[324]
These effects show the
approximate magnitude
[326]
of under performance
driven by respectively
[329]
a negative screen
[330]
and an integrated approach
to a sustainable portfolio
[333]
over the time period examined.
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As ESG preferences grows stronger,
[337]
the expectation is that
these pricing effects
[340]
will become more pronounced
[342]
in a 2019 paper,
[343]
Lubos Pastor, Robert
Stambaugh and Lucian Taylor
[347]
constructed a theoretical model
to examine the implications
[349]
of ESG investing on expected returns.
[352]
They, again, found that firms
[354]
with higher ESG scores
have lower expected returns
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and those expected returns get lower
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when risk aversion is low
and ESG sensitivity is high.
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They also found that the size
of the ESG investment industry
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increases as the dispersion
of ESG preferences increases.
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I know that was a lot to take in.
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So think about it this way.
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If everyone has the same ESG preferences,
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the same willingness to
invest in bad companies
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if the expected return is high enough
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and to invest in good companies,
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despite a low expected return
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then everyone will hold the
market portfolio and be happy.
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There will be no ESG investing industry
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if everyone has the same preferences.
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If there are two groups,
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one group with no ESG preferences
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and one group with strong ESG preferences,
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then there is an ESG investing industry.
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As the dispersion in
ESG preferences grows,
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the ESG investing industry gets bigger
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and expected returns for
sustainable portfolios
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get lower.
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Pastor, Stambaugh and Taylor,
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also found that sustainable investing
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leads to positive social impact
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by encouraging sustainable firms
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to invest more
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while discouraging unsustainable firms
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from investing due to the
effects of investor preferences
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on their cost of capital.
[427]
Let's recap.
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Yes, you can encourage change in the world
[430]
by investing in companies
that meet ESG criteria,
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but as long as there is
dispersion in ESG preferences,
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you are doing so at the expense
of lower expected returns.
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This joint effect must be true.
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If sustainable investing works the way
[445]
that it is supposed to,
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by putting pressure on
unsustainable companies,
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then the firms excluded
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from sustainable portfolios
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must have higher expected returns,
[454]
meaning sustainable investors
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must have lower expected returns
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than the preference free market.
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I think that we have established
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that investors should expect
lower risk adjusted returns
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from a sustainable portfolio.
[466]
A portfolio with a negative screen
[468]
that entirely eliminates industries
[470]
will tend to be more
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impactful to expect the returns
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than a portfolio with
an integration approach
[475]
that re-weights companies
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based on their ESG score.
[478]
In either case,
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lower expected returns are a consideration
[481]
for investors with above
average ESG preferences
[484]
reflected in their portfolio.
[486]
Lower expected returns
are not the only cost
[488]
that's sustainable investors endure,
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by definition a sustainable portfolio,
[493]
must be less diversified than the market.
[495]
A reduction in diversification
[497]
reduces the reliability
of the investment outcome.
[500]
If companies with high ESG scores
[502]
had higher expected returns,
[504]
the increased concentration
and decreased reliability
[507]
could be viewed as a reasonable trade-off.
[510]
But companies with higher ESG scores
[511]
have lower expected returns.
[513]
We are getting a less reliable portfolio
[515]
with a lower expected return,
[517]
not an optimal trade-off.
[520]
We also have to consider fees,
[522]
a globally diversified portfolio
of Canadian Listed iShares
[525]
ESG ETFs comes with a cost
of around 0.28% per year.
[530]
While a similar iShare the ETF portfolio
[532]
with no ESG consideration
would cost 0.12% per year,
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lower expected returns,
less diversification
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and higher fees are the costs
of a sustainable portfolio.
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These costs exist on a continuum.
[545]
The more sustainable that we want to get
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the higher the costs tend to get.
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If we start on one end of the spectrum
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we might have XIC,
[553]
the iShares core S&P/TSX
capped composite index ETF.
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No ESG filter, market cap weighted,
[560]
235 holdings and a 0.06% expense ratio.
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It will almost certainly deliver
[566]
the market's return after costs.
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XESG, the iShares ESG
MSCI Canada Index ETF
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favors companies with high ESG scores.
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It has 129 holdings and
an expense ratio of 0.22%.
[581]
MSCI has designed the index
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to have an expected 1% tracking error.
[585]
So you expect to get
the market return plus
[587]
or minus some random error.
[589]
If we wanted more sustainability,
[591]
we would need to increase
the tracking error budget
[593]
and expect higher fees.
[595]
For example, the Desjardins RI Canada
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low CO2 index ETF has 63 holdings,
[601]
more exclusions and stricter ESG criteria.
[605]
It has an expense ratio of 0.29%.
[608]
As we move along this
continuum of trade-offs,
[610]
the higher costs might be worthwhile
[613]
if the result is a portfolio
that increasingly aligns
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with your views and values,
[617]
but this is one of the biggest problems
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that sustainable investors face.
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There is a huge difference
between investing in a product
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with ESG green or sustainable in its name
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and investing in a way that
aligns with your values.
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Even the rating agencies,
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that determined the ESG scores
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don't agree on the definitions.
[635]
This was explored in a 2019 paper
[637]
by Florian Berg, Julian
Kolbel and Roberto Rigobon.
[641]
They looked at ratings
[642]
from five prominent ESG rating agencies
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and found that their ESG ratings
have an average correlation
[648]
of 0.61 with a range
between 0.42 and 0.73.
[653]
The disagreement is driven nearly equally
[655]
by differences in ESG definitions
[658]
and differences in how those
definitions are measured.
[661]
For context, credit ratings
[663]
from Moody's and Standard and
Poor's are correlated at 0.99.
[666]
We can look at the MSCI Canada
IMI extended ESG focus index
[671]
as an example.
[672]
This index takes an integration approach
[674]
combined with total exclusions,
[675]
for tobacco, controversial weapons,
[677]
producers of, or ties
with civilian firearms
[681]
and businesses involved
in severe controversies.
[684]
All good things to avoid for
a socially conscious investor.
[687]
Now here's the issue.
[688]
One of its largest holdings is Suncor,
[691]
a Canadian energy company specializing
[692]
in synthetic crude
production from oil sands.
[695]
More than 16% of the index is
made up of energy companies.
[699]
A different index provider
[700]
FTSE creates ESG indexes that exclude oil,
[703]
gas and coal companies.
[705]
They don't exclude downstream companies
[707]
like pipelines but it's still
a step in the right direction.
[710]
This difference in ESG index construction
[712]
it should be a surprise
[714]
from the Berg, Kolbel and Rigobon paper,
[716]
we can see that energy specifically
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is a major point of disagreement
across ESG rating agencies
[722]
with an average rating
correlation of only 0.29
[725]
at the energy category level.
[727]
The inclusion or exclusion
of oil and gas companies
[730]
in an ESG index is only one
example of a larger problem.
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Name your social or
environmental issue of choice
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and different index providers
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are likely to treat it differently.
[740]
Similarly, if an index
provider treats one issue
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the way that you would hope
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they might not align with
your views on other issues.
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This is a big problem
from two perspectives.
[750]
Investors might end up
enduring the higher costs
[752]
of a sustainable portfolio
[754]
while owning companies that
conflict with their values
[757]
and companies might be
confused about which actions
[760]
they need to take to improve
their ESG performance.
[762]
Approaching the sustainable
investing problem
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successfully ends up
requiring precise management
[768]
of the trade-offs between
implicit and explicit costs
[771]
and your specific set of views and values.
[774]
The perfect portfolio from the
perspective of using values
[777]
couldn't end up being
too under diversified
[779]
too expensive or otherwise impractical.
[782]
On the other hand,
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the simplest cheapest and
most diversified portfolio
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is likely to conflict
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on some level with the views and values
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of most sustainable minded investors.
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Step one for a sustainable investor
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is understanding
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that as long as there is
dispersion in ESG preferences
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sustainable portfolios have
lower risk adjusted returns.
[802]
Step two is making a decision
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about the acceptable level
of portfolio trade-offs
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in meeting the ESG preferences
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that you have
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where stronger ESG preferences
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will generally mean less diversification
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lower expected returns and higher costs.
[817]
Step three is probably
the most important step.
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It is verifying that the
products that you have selected
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truly reflect the views
and values that have
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motivated you to be a
sustainable investor.
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Thanks for watching.
[827]
My name is Ben Felix of PWL capital
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and this is Common Sense Investing.
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If you enjoyed this video,
[832]
please share it with someone who you think
[834]
could benefit from the information.
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Don't forget,
[836]
if you have run out of
Common Sense Investing videos
[838]
to watch,
[839]
you can tune into weekly episodes
[840]
of the rational reminder podcast
[841]
wherever you get your podcasts.
[842]
(upbeat music)
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