Morgan Stanley: ESG survey of asset owners

July 5, 2018 Ben Yeoh

Morgan Stanley: "Sustainable Investing has gone from a niche investment idea to attracting enough capital to start having an impact on global challenges at a meaningful scale. The intensity of recent growth has been driven by a fundamental shift in how investors and asset owners view environmental, social and governance (ESG) factors."

MS polled 118 asset owners.

- 84% of asset owners surveyed are at least “actively considering” integrating ESG criteria into their investment process

- 60% of asset owners integrating ESG into their investment process have only begun doing so within the last four years and 37% within the last two

(Me: This suggests movement is still in early days, though MS argue it is moving mainstream)

-78% of respondents listed risk management as an important factor driving their adoption of sustainable investing.

-77% of respondents also focused on generating returns.

The link to the survey paper is here. It chimes with the CFA ESG survey I posted about previously.

I do think that answer that 37% of asset owners only started thinking about ESG in last 2 years suggests that this might still be the early days of the movement - and if asset owners eventually reflect the end beneficiaries, which for the most part is the "person n the street" and if she increasingly younger and more interested in sustainability, then the movement has legs...

Amel-Zadeh: ...ESG information is material to investment performance. However, which information is material likely varies systematically across countries (e.g. a country where water pollution is a more serious issue versus a country where corruption is a more serious issues), industries (e.g. an industry affected dramatically by climate change versus an industry affected by violations of human rights in the supply chain) and even firm strategies (e.g. firms that follow differentiation versus low price). For example, Khan et al. (2016) show that the vast majority of ESG data for any given industry is immaterial to investment performance and that the material information varies across industries within a sample of US stocks. Understanding how the materiality of ESG information varies across countries, industries and firm strategies therefore is of primary importance...”

This to my mind, along with this study on the benefits of Active Ownership and ESG engagement and if one puts this work together with the work on the outperformance of Global Equity managers described here, one can start to build a defense of Active Management for global managers for those using ESG....

If you'd like to feel inspired by commencement addresses and life lessons try: Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude or investor Ray Dalio on on Principles.

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Divesting sectors. The impact on returns. Evidence that oil divestment may not impact returns.

June 22, 2018 Ben Yeoh

Source: Jeremy Grantham, writes (see link to LSE talk  here): note cavests below. — Source: Jeremy Grantham, writes (see link to LSE talk here): note cavests below.

Grantham and colleagues have looked at the S&P500, over the last 28 years, 60 years, and 90 years; excluding a major sub-component sector each time. Grantham’s overall conclusion it that it didn’t make much difference in return - although some might argue at the max range of 50bps that compounded over 28 years may be significant. Others might suggest that the power of diversifcation and time, also makes this conclusion unsurprising.

Caveats could include: not peer reviewed (although I have found similar conclusions with slightly different data sets), different exclusions may produce different answers (specifically Tobacco might come up as a narrow exclusion; cf Dimson’s data set on “sin stocks”), and that S&P500 is not world representative (however it has the best long run data set, and is a widely used index that does represent a facet of corporate America).

Grantham writes (see link to LSE talk here)

“So my colleagues and I finally carried out a test to see exactly how an investment portfolio would have been affected by divesting from a group of companies that are listed in the Standard and Poor’s 500, the index based on the market capitalisations of 500 large companies listed on the New York Stock Exchange or NASDAQ.

These companies can be divided into 11 sectors (not including real estate). We considered the 10 long-term sectors (real estate was added relatively recently), and analysed how the index performed without each sector.

Initially, we considered the period from 1989 until 2017. [The results are shown in Figure above]. You will see how dramatically the index changes with the removal of each sector – there is only a 50 basis points difference between the best and the worst. They are basically all the same!

You will see that excluding the information technology sector made a small difference for a few years around the turn of the millennium. That was the technology bubble. Beyond the burst of the bubble, all of the indices track together again, as if nothing had ever happened.

But basically, all of those 10 variations of the index track between 1989 and 2017 as if they were the same. So we decided to see what happened if we chose a different period, incase there was something extraordinary about the past 28 years. We extended the analysis, first to start from 1957, and secondly to begin in 1925.

You will see in chart above that changing the period of analysis does not make much difference. The difference between the best and worst is 54 basis points instead of 50. So over 90 years, it would not have cost an investor to have divested from any one of the sectors.”

Grantham further writes:

“Who knew that the stock market was that efficient? It may be hopeless in bubbles and busts, but it has evidently priced these groups of big companies pretty well. And there is no advantage to an investor of choosing the high-growth information technology sector over, say, utilities. Utilities are priced down and information technology is priced up, but they produce the same returns. It is amazing.

What does this mean for divestment? It means that if investors take out fossil fuel companies from their portfolios, their starting assumption should not be that you have destroyed the value. Their starting assumption should be until proven otherwise. that it will have very little effect and is just as likely to be positive by 17 basis points as negative. That is an amazing contradiction to what every investment committee has ever said, as far as I am concerned.

It obviously takes a major miscalculation to move the dial when it comes to divestment. I think that decarbonisation is just such an event. And the reason I think that is that the oil companies and the chemical companies are not rolling with the punches. They are fighting decarbonisation tooth and nail. They are still funding obfuscation programmes in North America. And if you do that as a corporation, as a capitalist, you are likely to bite the dust if you are facing a major change, if you fight it. And they are fighting it. If they rolled with the punches, they might do quite well, and bleed off their capital and pay big dividends. But they are not doing that.”

I’d like to add a thought or two on the theoretical framework here. There are two to note one is

The Active Law of Fund Management which suggests the bigger the investment universe the better the risk/return potential, and,

The Efficient Market Hypothesis which suggests information is priced in efficiently such that it is hard to outperform large diversified markets

Both are theoretical although backed up by certain lines of empirical evidence (I’ve been drafting a long blog on the EMH for a while, hopefully out one day), although both are not considered perfect to explain what we can observe empirically.

As Grantham alludes to, this suggests the power of reasonable large scale diversification, and time. It seems to suggest over long periods of time, no one sector has such strong outperformance that it significantly dwarfs a large fairly diverse group of companies/stocks. I’m guessing there are always 400 to 450 stock left in any one excluded portfolio.

It’s an interesting challenge to certain notions of thematic and smart beta ideas as well, although those assessed differently.

Many of us are in the forward looking future prediction game. Although again, this might suggest, as Warren Buffet and Jack Bogle do that the average investor is then best off in low cost trackers (although note possible limited stewardship??!!), and if they wish to lose a sector or two it’s not likely to be a big impact (perhaps a small plus or minus in the order of 25 to 50bps; and arguably hard to predict although as Grantham argues, it might be oil, chemicals but for business related reasons).

I actually see Grantham’s work replicated in shorter run indices. You can look them up put the ex-Tobacco or ex-fossil-fuel type indices over the last 5 to 10 years have all done better or in the same ball park than the standard index. 5 years is short run, but might suggest that something has happened in the last 5 years perhaps different to eras further back.

In any case, back to oil divestment, so you need to know Grantham has a long time view (bias) here and sponsors the Grantham institute. Might mean he is right and has spent a long time thinking about this. He’s being doing investment (albeit more macro and asset class lens) for much longer than me.

Still, this is a decent evidence base and theoretical framework for arguing for the divest – stranded asset argument. It also highlights the area for engagement, if it can help bend these companies at all.

This all comes from a talk given in April 2018 at the LSE.

Source: LSE lecture (link here), although Grantham is quoting HSBC work

In the lecture, Grantham is mainly focused on climate, weather and food. Slides here, talk below.

On climate - click here for more carbon related posts. There's an argument made by risk philospher and Black Swan author Nassim Taleb on why we should lower pollution regardless of models.

The current Arts blog, cross-over, the current Investing blog. Cross fertilise, some thoughts on autism. Discover what the last arts/business mingle was all about (sign up for invites to the next event in the list below).

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

Some popular posts: the commencement address; by Nassim Taleb (Black Swan author, risk management philosopher), Neil Gaiman on making wonderful, fabulous, brilliant mistakes; JK Rowling on the benefits of failure. Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

The dawning of Japanese Corporate Governance

June 20, 2018 Ben Yeoh

Source: Board Independence graph is Yanagi's book quoting ISS survey 2012-13

I recently finished a positive stewardship engagement with a Japanese company on the nature of independent directors. ESG ignored 10 years ago, is increasingly in focus in Japan. In my view, this trend is set to continue.

One resource to examine in this area is Ryohei Yanagi’s new book on corporate goverance in Japan (Amazon link here). Yanagi has a book event in London 4 July 2018 (link to event here).

Yanagi examines the Ito review (cf UK Kay review, a blog on Kay here), the corporate governance and stewardship codes in context of Abe’s reforms, and gives the historic background of why Japanese corporates are managed and governed like they are today.

Source: the RoE (Return on Equity) chart is based on RoE average primary index of each country (cap weighted), on 4Q (2004-2013( by Bloomberg data, from Moving the Mountain study group, 2014 from Yanagi (2018)

He discusses RoE (Return on Equity) and RoE - cost of capital spreads.

Since the work of Stern Stewart and others on EVA (Economic Value Add) from the 1990s and before (see a background paper here) which focus on Return on Invested Capital (or for some in modern day expressions Cash Flow Return on Investment) over some assumption of cost of capital, this thinking has been a dominant feature in US and EU corporate thinking and finance. Less so, seemingly in JP corporates.

Yanagi then synthesises this with ESG and intangibles and coins a concept of RoESG.

Yanagi suggests many Japanese corporates view some of their intangible ESG/CSR management as good (although again one can debate on reporting on it). (I also think many non-Japanese investors may not concur with what Japanese manager tout on CSR)

He then suggests that intangible/ESG management and management of RoE are two lens which are not opposed – in fact almost could be joined more symbiotically.

Not an entry level book, it draws practical thinking about how to look at financial and non-financial metrics for corporates and investors alike and roots it in the historic and cultural context of Japan.

Impact Investing in the UK

June 16, 2018 Ben Yeoh

Impact Investment Opportunity in UK, this week I was listening to Elizabeth Corley and expert speakers on the opportunities and challenges for impact at a social impact investing conference.

Some questions raised:

What are the dangers and advantages of speaking about ESG and Impact in the same breath? How important is a common language? Taxonomy? Standardised outcomes?

Fear of unintended consequences of regulation? “Backed by regulators” not equal to “regulated” ? Is it beyond the wit of the industry to find a better way to represent individuals wishes re: Impact ?

Will SDGs used as part of "SDG washing" - something that looks good for marketing but doesn't make real impact.

There is debate in impact world on if you can make market returns and still have measured deep impact. This notion of a continuum or spectrum of thinking about these ideas is one which is taking shape.

However, when thinking about this in mainstream instiutional or retail investment, I think it has a long way to go before it's embedded in thinking. I base this observation on the minimal mainstream press or adviser coverage and the small knowledge base / marketing at retail or adviser level. Still, the movement is growing and ideas which start here will hopefully go on to seed bigger things in the mainstream too.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

ESG matters, both for operational and share price performance. Nordea.

June 4, 2018 Ben Yeoh

Nordea “As ESG performance has grown significantly in importance for companies and asset managers in recent years, it's time to look at the numbers. Is ESG screening a worthwhile tool? In a word, yes. High ESG focus contributes to risk mitigation; our research shows this is mirrored in strong operational and share price performance. We also note that predictive attributes as to future earnings stability and share price volatility suggest that ESG research belongs in company valuation. We argue that companies and investors simply cannot afford not to care.

Note sample size for CCC is small and "special sit" companies often fall in here too eg post a poor ESG controversy.

Key conclusions: We see solid evidence that ESG matters, both for operational and share price performance The relative performance of the top versus bottom ESG performers amounted to as much as 40% in 2012-15 ESG is largely uncorrelated with our quant factors, and incorporating it adds alpha to our value and quality strategies.

ESG as a driver for operational improvement. We find a consistent correlation between ESG ratings and operational metrics. For example, companies with top ESG ratings have higher ROE and ROCE, and lower net debt/EBITDA than the market. Returns, margins and share prices are also more stable for the top-rated companies and we find that improving ESG performance bolsters stability in returns, implying it is not a lagging indicator.

ESG adds alpha to already proven quant factors We find ESG of great interest as an addition to our quantitative framework. An intuitive auto-correlation between ESG and quality, which share a lot of characteristics, did not materialise, but ESG added alpha to our quality strategy.

Link to research from Nordea

This chimes with a recent BAML Study using a different ESG database – see blog here.

You can also see it in conjunction with these papers here:

from MSCI and ESG and higher RoIC companies

from Caroline Flammer on long term incentives and causal evidence for ESG nad other Academic ESG papers.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Quant Survey ESG and other Factors

May 20, 2018 Ben Yeoh

BAML 2018,   Savita Subramanian (BofAML, Quant team) — BAML 2018, Savita Subramanian (BofAML, Quant team)

What to learn from Quant and ESG? Assets in smart beta have grown at a ~30% annualized rate since 2009, quant jobs outnumber fundamental jobs 5-to-1, and >60% of investors blend quant and fundamental techniques. Quant models have grown increasingly complex, with investors using 17 factors in their models today vs. 7-8 in the 90s.

ESG saw the third-biggest increase in usage of any factor – 26% of clients use it today vs. 19% last year. Social/moral considerations were still the primary driver for use, followed by risk-mitigation.

Investors with both short- and long-term time horizons are using ESG, vs. a skew toward longer-term investors a year ago.

This from the BAML US Equity & US Quant Strategy. See previous blog on their ESG work. Also of note:

Momentum is crowding out Growth & Value

Value and Growth factors were tied as most popular (both used by 38% of clients), but both saw a decrease in usage vs. last year, while Momentum strategies saw the biggest increase in usage.

Value still dominates the models for the 12th year running, thought it saw a drop in popularity vs. a year ago (used by 70% vs. 80% of clients). Relative Strength, a Momentum factor, saw the biggest uptick in usage vs. last year.

Still only a minority of quant funds are using ESG as a signal, even though they are using around almost 20 signals on average.

This gives me some comfort as a bottom-up fundamental active manager. However, the data is looking increasingly powerful on the quant side as well. There have been positive findings across other ESG data sets (with Sustainalytics and MSCI being the two other most used data sets; this one is the Thomson Reuters data set), although the correlation between these data sets remains relatively poor at between 0.3 to 0.5 in the studies and work I have seen.

The other factor this work and similar raises is the power of passively managed funds. They now make up over 40% of US-dom equity funds up from 20% in 2009, and I do not see this trend changing any time soon. In fact various forces may if anything accelerate this trend.

Vanguard now owns more than 5% of over 494/500 S&P 500 companies. Vanguard is now the steward of many people's capital. That man in the street through Vanguard now owns 1/20th of the largest companies in the US. It will be interesting to see how stewardship evolves in this situation.

More thoughts:   My Financial Times opinion article on the importance of long-term questions to management teams and Environment, Social and Governance capital.

One of the best Munger speeches on how to think about a mental model of inversion can be found here.

March 2018 thoughts on greed, fear and risk.

MSCI paper on high ROIC companies and ESG.

Causal evidence for benefit of long-term incentives

May 15, 2018 Ben Yeoh

In ESG world, I wanted to highlight this paper from Caroline Flammer and Pratima Bansal. (H/T Alex Edmans) It’s causal evidence for the benefit use of long-term incentives. The paper studies shareholder proposals that not only are on executive compensation, but specifically advocate the use of long-term incentives. (Link to paper here)

The authors use a “Regression Discontinuity Design”. They compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether you narrowly pass or narrowly fail is essentially random, and uncorrelated with other factors. So, it’s causal evidence.

They find that proposals to increase long-term compensation improve long-term operating performance, regardless of whether you measure it using return on assets, net profit margin, or sales growth.

From abstract " In this paper, we theorize and empirically investigate how a long‐term orientation impacts firm value. To study this relationship, we exploit exogenous changes in executives' long‐term incentives. Specifically, we examine shareholder proposals on long‐term executive compensation that pass or fail by a small margin of votes. The passage of such “close call” proposals is akin to a random assignment of long‐term incentives and hence provides a clean causal estimate. We find that the adoption of such proposals leads to (1) an increase in firm value and operating performance—suggesting that a long‐term orientation is beneficial to companies—and (2) an increase in firms' investments in long‐term strategies such as innovation and stakeholder relationships.

In sum, Caroline Flammer (LI profile) and Pratima Bansal suggest corporate short‐termism is hampering business success. Authors show clear, causal evidence that imposing long‐term incentives on executives improves business performance. Firms that adopted shareholder resolutions on long‐term compensation experienced a significant increase in their stock price. This stock price increase foreshadowed an increase in operating profits that materialized after two years. Discussed: reasons for these improvements - firms that adopted these resolutions made more investments in R&D and stakeholder engagement, especially pertaining to employees and the natural environment.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Cross fertilise. Read about the autistic mind here.

Investing and Responsibility

May 7, 2018 Ben Yeoh

Part of the reason I’m passionate about this job is that I believe through my role I have some influence in making (good) companies even better and hence moving capital to good ideas and good companies and away from bad ideas and companies (self-delusional maybe).

(It’s part of why I write about stories that are not often told, when I write plays)

So, it’s both a privilege and a responsibility (yes, Spiderman with great power comes…) to have a two-way conversations with Chairs of companies, billionaires, CEOs and the like… about the long-term, business, sustainability… diversity, employees, operations… the list is long.

(Thoughtful) investors are uniquely placed to have influence at board and senior management level at the most influential companies in the world. (Unthoughtful investors too).

In many ways our influence is overstated. Why should a governance/[insert specialty here] analyst a few years out of university with some understanding about governance frameworks, but limited understanding of the business, have such a say at setting incentives over a committee or board of combined 100s year of relevant experience? So, it is up to those like us, who are interested in the long term, and understand business to make the case both to companies and to pension fund and asset owners alike that we are thoughtful and (socially, financially, strategically) useful.

There are few, if any, easy answers to complex questions. In some ways, staying out of contentious issues (eg don’t invest in Rio Tinto, don’t in Shell) is an easy way of signalling virtuous intentions. As I mentioned on my post on Rio, the fact that selling coal mines doesn’t make them go away is awkward. (Although you can also make the point on new capacity….)

In any case, I’d like to make the case that investors and pension fund managers (some of them at least) are heavily involved in these debates. You can see it across a range of matters – the heavy (live) debates over Shell (as seen through Share Action, Environmental Agency and others, vs Shell management position here), to where we have come to on incentive plans at Weir (FT article here) or Unilever.

I don’t claim to have answers to many of these problems (although in the case of carbon, a carbon tax might help) but we are trying to think about them….

One person to be thinking on these matters a long while (we met back in the early 2000s), is Raj Thamotheram. Raj has cancer and this is a piece in IPE where he reflects on sustainability learnings from the lens of his illness.

Raj is also looking for a Chair for his sustainability think tank - see the role here (1 June deadline)

One of the best Munger speeches on how to think about a mental model of inversion can be found here.

If you'd like to feel inspired by commencement addresses and life lessons try: Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Sheryl Sandberg on grief, resilience and gratitude or investor Ray Dalio on Principles.

Cross fertilise. Read about the autistic mind here.

More thoughts:  My Financial Times opinion article on the importance of long-term questions to management teams and Environment, Social and Governance capital.

 How to live a life, well lived. Thoughts from a dying man.