Market Thinking

making sense of the narrative

ESG – be careful what you wish for

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As we noted in Wednesday Wanderer’s Wonderings, one of the biggest differences for markets between a Biden or Trump Presidency is likely to be that the former will embrace the concept of a Green New Deal and by extension ESG investing, whereas the latter will continue to resist it. This is picked up by Gillian Tett in the FT today, who suggests that this might cause a momentum rally in ‘green stocks”. In fact that is clearly already happening as we discuss below in our analysis of our model portfolios. Indeed, we suspect it is also a factor in the broader tech rally since most ESG strategies to date have in reality been short energy/long tech.

Many would say that that is a ‘good thing’, after all, ‘everyone agrees’ that ESG is the way forward. Certainly every big fund management house in the world is pushing its ESG credentials and every large corporate is now ‘teaching to the test’ on sustainability issues to make sure it stays on the approved list. At the same time, any underlying investor with any public sector connections is now insisting on ESG mandates. However, as ever, when ‘everyone agrees’ on something it is right to be cautious. Thus amid all the feel good rhetoric it might be worth issuing a few words of caution here.

First, we need to be very careful about the claims that ESG outperforms. As mentioned, the recent ESG performance has essentially been a Short Oil/long Tech strategy. The problem now is that whereas being underweight Oil previously meant being underweight a sector that was more than 10% of the market as it fell 80%, the maths means you are now simply underweight the smallest sector in the market. Indeed energy is now a smaller weight in the S&P than Microsoft. This will now be much harder to replicate.

Then of course there are all the inherent contradictions around the E of ESG. For example, what do we do about legacy businesses? Do we refuse to provide capital to a business that is becoming more ‘green’ because of where it is coming from? Or are we going to let it have cheap capital to encourage it to do ‘good’ things? What about a mining company that has coal (bad) but also copper (good for electrification). What about if it also has uranium? Is that good or bad? Is Tesla good because of no emissions or bad because the electricity the cars use comes from coal fired power stations? (although logically that would apply to every company in the world.) Do we blacklist a power company that is switching to gas in its home country but also has coal fired power stations in, say, Africa, that provide much needed cheap electricity as an alternative to cooking over open fires?

The reality is that there are no ‘right’ answers to these sorts of questions – indeed exactly these issues have dogged Government aid programmes for decades – but a Global ESG system will demand rulings. This will inevitably give enormous power and influence to whoever is given this role. In effect whoever sets the rules and declares the eligibility will become the de facto CIO of over $6trn of other people’s money. The ultimate centralisation of financial power.

As such we should not fool ourselves that this does not represent a public sector takeover of private sector savings. However good the intentions, investment management companies will no longer be aiming to generate the best risk adjusted return for underlying savers, they will be constrained into only allocating into approved areas. These areas are essentially those set out under the UN sustainability goals and primarily involved with climate change, meaning climate change advocates would effectively be setting investment policy. Many people may think that is a good thing, but it needs to be made far more transparent, not least because it means we should think very carefully about what would happen next.

The problem is, that once such a system is in place, it is inevitably open to abuse. An obvious example would be that just as we already see with complex rules and regulations, large corporations would inevitably seek to raise costs of compliance with ESG in order to keep out smaller competitors. However, there are far more alarming consequences that provoke our headline of ‘careful what you wish for’. In particular we should be alert to the equivalent of financial no platforming, from the macro all the way to the micro.

How long for example before someone suggests that since China is ‘a major polluter’ that ESG funds (ie almost all western private sector savings) are not allowed to invest in Chinese stocks? Or that a certain company should be taken off an approved list for breaching some guideline or other? At the moment multiple investors make individual judgements, but this would be more akin to a credit rating agency declaring a bond move straight to junk status. It would trigger an immediate fire-sale. Perhaps more pertinently, it is difficult to see how major banks would then not be forced to constrain their own bank lending to ESG guidelines in order to maintain access to capital markets. How easy then would it be for activists to attack small or mid cap companies for doing something that is not illegal but which they don’t approve of and use the ESG club to do so? Sorry, you violated one of the UN sustainability goals which means we as a bank are unable to lend you any money (otherwise we lose our ‘license’). This of course could even apply to individuals – the equivalent of the Social Credit scores in China. It might not happen, but equally there would be nothing to stop it.

The chilling conclusion of this well intentioned move to adopt ESG as the default for all capital is that the UN sustainability goals would effectively become the equivalent of holy writ, their interpretation a matter for the high council of this new clerisy. There would be no way around them. As the old saying goes, Be Careful what you wish for. You just might get it.

Model Portfolios and Risk Matrices

The process we employ for monitoring and rebalancing our model portfolios is based around the notion of our risk heat maps – essentially level 5 is highest risk, level 1 lowest and our portfolio is tilted away from the former and towards the latter. At level 5 we will have zero exposure to that factor. If all factors are risk level 5, we will be at our maximum level of cash – which for these unconstrained portfolios is 100%. As can be seen in the tables below, this shows the progress between the end of January and the end of September plus from then until the latest date we ran – which was 14th October. For clarification, we run the risk matrices every day and act accordingly, but for simplicity we normally just publish the end month number.

Global Factor Model

End month, October is mid month

The Global Factor Model seeks to achieve diversification by investing across five global ETFs, each of which tracks an index of stocks conforming to one of the five factors deemed from the academic literature to generate long term returns. We allocate between the factors based on our proprietary risk matrices as shown in the heat map. We can see here that the first half of October has seen risk levels fall across most factors, with the exception of value, where risk remains elevated (and thus we have little exposure). To be clear, mostly the factors will move in smaller stages – the apparent big drop for min volatility from 5 to 1 did involve some intermediate moves. Note how risk was at 5 throughout February and March for all factors and came down across the board in April and May, only starting to diverge in July and August.

Global Bond Model

End month, October is mid month

For Global Bonds we diversify into five ETFs tracking different ‘types’ of fixed income. Here we can see High yield risk dropping, bringing it more in line with the other bonds, with Global Aggregate Bonds (also the benchmark) dropping back to lowest risk again. Note that these two were also the highest risk bonds in April. Also note that TIPS has been low risk throughout.

Thematic Equity

End month, October is mid month

Finally the Thematic Equity Model Portfolio seeks diversification through seven different global ETFS, mainly focused on growth. This is intended more as a ‘satellite” strategy, whereas the Global Equity Model is more of a ‘Core” strategy. Here again, the rebalancing between the ETFs reflects our risk reward judgements based on our risk matrices. We can see how there has been a reduction in risk since the end of September for both EM Consumer and Digital security, while all else has been pretty consistent since the summer. One particular thematic to watch is Gold, which we have as a counter to the growth ETFs, which was low risk from April through July but where risk levels started to rise in August and September and remains relatively elevated. The other one to mention of course is Global Clean Energy, which ties in with our earlier discussion about a momentum rally in ESG stocks, and is up 80% year to date.

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