January Thoughts from the Research Desk

In putting together my December Thoughts Piece, I touched on some of the different long-term risks numerous asset management firms outlined in their capital market assumptions. One of the risks that a few firms presented that I did not include in my piece was the long-term risk associated with climate change. From an investment perspective, climate risk is broken down into two subsections: physical risk and transitional risk. Physical risk is the risk of damage to buildings, land, and infrastructure because of natural disasters. While some natural disasters are getting easier to model out (as an example, insurance companies are getting increasingly better at probabilistic scenario analysis of hurricanes), the damage to an asset as a byproduct is not. An unexpected disaster, be it a hurricane or an earthquake, will disrupt supply chains, cause damage to factories, or hinder employee’s ability to work. In any one of those three examples there is no way to look ahead and be able to predict when a natural disaster will occur or what the ultimate financial impact will be. That said, investors are starting to be more cognizant in thinking of this type of risk. Per a Financial Times article (citing a BlackRock study), municipal bond issuers equivalent to about 15% of today’s market are likely to see weather-related impacts that could knock off 1% off of their economic value. Because of that, investors are favoring municipalities that have assurances written in about possible economic damages to ensure that they will be able to repay the bond.

Transitional risk, on the other hand, is the risk of material changes to a company as a byproduct of legislative and market forces. By identifying different geopolitical and market trends, an analyst can deduce which companies stand to either benefit or lose out when new climate-related policies are put in place. An increase in higher fuel standards, increased requirements for clean energy, or even updated building codes are things that an analyst can model. If the company can make those changes, they have considerably less risk, which will be taken into account in the analyst’s model. This type of analysis has been going on for some time and is known as either Responsible Investing or ESG Investing.

Environment, Social, and Governance (ESG) investing, or some form of Responsible Investing (RI) is not a new concept, but it does have a negative connotation among investors. One of the largest and oldest ESG exchange traded funds (launched in 2015), the iShares MSCI USA ESG Select ETF (SUSA), is designed to maximize exposure to favorable environmental, social and governance ("ESG") characteristics. However, due to its composition, it underweights or completely excludes certain companies that do not score well on its index. The index leads to questionable exclusions and, in the case of many existing ESG ETFs, including SUSA, market underperformance. Since inception, SUSA has trailed the S&P 500 Index by 33%. Eric Balchunas, an analyst at Bloomberg who focuses on ETFs, recently wrote a great piece about the complications of rules-based ESG ETFs and how it opens up a lot of room for interpretation and what to exclude. The openness of what constitutes a good ESG investment and whether it should be included or excluded in a strategy is the big question that investors have been dealing with. Numerous surveys that I have read have suggested that investors want to invest in ESG investments but would not do so at the cost of underperformance.

That said, those same surveys show that there is increasing interest in ESG and Responsible Investing. A 2018 Nuveen Responsible Investing Survey showed that 93% of millennials are interested in RI (vs. 78% of non-millennials). In 2019, the US ETF business grew by 30% according to etf.com. Seeing all of that, several asset management firms are spending a lot more time and energy in creating various ETF strategies. Most notably, BlackRock's CEO Larry Fink recently announced that they will double the number of sustainability-focused ETFs it offers to 150. They will also lower the number of companies they own that derive a quarter or more of their revenues from thermal coal and increase its ownership of sustainable assets from $90bn today to $1t by the end of the decade. On the governance side, State Street and Goldman Sachs have made a big push about not investing in companies that do not have a diverse board of directors.

So, as we head into 2020, what do these latest developments mean? From a macro perspective, active pressure from some of the largest investors (the Blackrock's and Goldman's of the world) could lead businesses to have better ESG ratings and lower material risk. From an investor perspective, the benefit of increasing interest in ESG investing has been a modification of strategies. As more and more asset management firms are looking to incorporate ESG into their portfolios, they are coming up with different ways to account for ESG Criteria and how to best incorporate it into their investment decision-making process. Rather than a pure "exclusionary" method, an arguably better way is to look at an asset’s (whether it is a company or a municipal bond issuance) material ESG risks and account for them as part of the traditional fundamental accounting process.

The good news is that there are already strategies (including one we invest in) that are incorporating this type of process and identifying more of these types is at the crux of my research goals for the upcoming year. I intend to come up with an ESG influenced model that has a similar risk/return profile as our existing models for those that wish to follow suit of the large asset management firms and incorporate ESG in their portfolios.