6 min read 28 Jan 19
Summary: Not that we needed anybody’s reassurance, but the UK government’s decision that pension fund trustees must consider financially material ESG (Environmental, Social and Governance) factors in their assessments, definitely helps those who believe that sustainability is becoming a need more than a choice – for society and investors alike.
In my view, an ESG lens can help monitor qualitative risks and assess corporate management style as well as priorities in order to prevent single name idiosyncratic drawdowns. ESG considerations are particularly important for High Yield (HY) issuers, usually more leveraged and therefore more likely to amplify any positive or negative news.
A Barclays study recently found that HY portfolios with a high-ESG tilt tended to outperform, with the Governance component being the most important of all. Intuitively, this makes sense as lending to well-run companies, where interests are aligned with bondholders, should pay-off in the long run.
We should also remind ourselves that what’s good for the share price is not always good for credit risk. Take for example a private equity ownership which incentivises maximum leverage and/or major shareholder returns.
While performance links of Environmental and Social factors are less clear, I still argue that companies must also consider the externality of poor environmental and social practices in the long term. The short-term cost saving of cutting wages or avoiding clean-up costs is increasingly outweighed by the long-term financial damage of such actions.
Investors are increasingly focused on these qualitative factors and this, combined with the explosion of big data, is bringing a level of transparency that is leaving many faces blushed. Excessive behaviour will be more quickly punished as non-financial information is now readily available and can be measured in real time. For instance, the presence of social media means that even in remote areas of Africa, a company that leaves a mine full of contaminants might not be granted access to exploit a new mine in Chile. A handful of ESG data providers have already emerged to tap increasing demand and I forecast a bright future for those service providers.
However, asset managers need more than third party ESG research. Here are some recommendations that may help:
In principle it makes sense that better ESG performance leads to higher profits, and therefore to a stronger balance sheet and a better rating, but I don’t think this logic holds given that ESG data is not efficiently priced into markets yet.
I think IG’s better ESG performance is largely due to an information bias: IG companies are usually blessed with a PR department that showcases the company’s ESG efforts; in contrast, and according to a recent PRI report (“ESG Engagement For Fixed Income investors”), only 20% of global HY issuers reviewed and confirmed MSCI’s summary of the data it uses for their ESG scores, dropping to just 3% for privately-owned companies. This may mean that the HY ESG data might not capture the full picture and therefore may be unsuitable to draw any conclusions from. Asset managers with big in-house analyst teams may be able to access more relevant but less available data in order to reach a more comprehensive conclusion.
All in all, while ESG data providers can offer an initial framework and some guidance, active asset managers need to up their ESG capabilities to maximise alpha for their investors.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.