Lecture 4 Flashcards
What is ESG integration?
Targets reducing portfolio risks or volatility, increasing returns, or adding value to the portfolio’s effect on society or the environment
How is ESG integration implemented?
- ESG score based analysis
+ Picking individual firms (active)
+ Positive screening (passive) - Thematic screening (pick a topic for selecting stocks)
Evidence of ESG
- ESG performance
- Value drivers
- Stock performance
- Investor performance
ESG integration into fundamental equities
steps Value driver adjustment (VDA) approach
- Identify & focus on the most material issues
- Analyse the impact of these material issues on the individual company
- Quantify competitive (dis)advantages to adjust for value driver assumptions
- Have an active dialogue
Corporate social responsibility effect (not directly SI)
- Higher sales, lower financial volatility
- Better access to funding
- Higher trust and resilience
Blitz & Swinkels
Does excluding stocks cost performance?
Conclusion
- Exclusions involve risk relative to the market and peers
- It is unlikely that excluding sin stock generate a higher cost of capital for them (no ESG results)
Dimson
Goal
Does engagement work? Does it affect financial performance? Does it affect returns?
Dimson
Conclusion
Success in engagements is more probable if:
- the engaged firm has reputational concerns
- has higher capacity to implement changes
- has been engaged successfully before
- there is collaboration
Blitz & Swinkels
Does excluding sin stocks cost performance?
Solutions
- Tracking error may be minimized and expected portfolio return restored by filling the gap left by excluding sin stocks with non-sin stocks that offer similar hedging properties and factor exposures
- Mimic the Sharpe ratio of the market
Dimson
Conclusion
Successful engagements, particularly on environmental/social issues, generate:
- improved accounting performance
- better governance
- increased institutional ownership
- better financial performance (not very strong results)
Goals of ESG integration
- Optimizing the portfolio risk/return trade off by taking account of ESG factors (1.0 optimize F subject to E&S)
- Achieve a compromise of optimal portfolio outcomes and ESG outcomes at the same time (2.0 optimize E+S+F)
Investing based on (..) is driving up prices of such stocks at the moment
Scores and themes
CSR is also considered (..), as it has an indirect effect on ESG (..)
Therefore, ESG scores can help to (..)
SI, through better financial performance
Identify social responsible companies
Conclusion CSR
Support SI 2.0: taking account of ESG factors primarily (..)
However the target is (..), not the ESG
In the fundamental analysis of firms
The financial returns
Evidence of ESG
- ESG performance
- Scores/ratings
- Material vs immaterial
Evidence of ESG
- Value drivers
- Sales growth
- Margins
- Cost of capital
Evidence of ESG
- Stock performance
Type of companies
Evidence of ESG
- Investor performance
Approach: ESG integrated vs ethical
Blitz & Swinkels
Does excluding sin stocks cost performance?
Goal
The impact of excluding sin stocks on expected portfolio risk and return
Blitz & Swinkels
Does excluding sin stocks cost performance?
Relationship
Investment choice directly on investment return
Blitz & Swinkels
Does excluding sin stocks cost performance?
Financial arguments
Pro-exclusion: Sin sectors have no long term future, so they will underperform relative to other sectors
Against exclusion: Reduces diversification, which increases portfolio risk.
Blitz & Swinkels
Does excluding sin stocks cost performance?
Background
- Tracking error: return deviation of an investment portfolio from the return of the market portfolio
- In CAPM, deviating from the market introduces risk and a rational investor seeks compensation
- The exclusion portfolio does not give the required return because it does not sit on the tangency line
- Sin sectors are expected to outperform the market according to Fama-French-5-Factor
- Sin premium – they are cheap enough for the cash flow they generate
Dimson
Does engagement work? Does it affect financial performance? Does it affect returns?
Stewardship
Pay a company to engage on your behalf according to your principles
Dimson
Does engagement work? Does it affect financial performance? Does it affect returns?
Data
Engagements performed by an institutional investment firm on U.S. companies, concerning ESG factors
Dimson
Does engagement work? Does it affect financial performance? Does it affect returns?
Engagement success
- Apple Inc. announces eliminating toxics and more recycling
- Yahoo Inc. commits to human rights and freedom of expression online
- Illinois Tool Works Inc. publishes a Sustainability Report
Dimson
Does engagement work? Does it affect financial performance? Does it affect returns?
Problems
Not explained deeply about engagement results
Only one investor data is used
Dimson
Does engagement work? Does it affect financial performance? Does it affect returns?
Conclusion
A company is more likely to be engaged if it is:
- Large
- Old
- Performs poorly
- Sensitive to reputation
- Weak governance
- Investor shareholding is large
Successful (unsuccessful) engagements are followed by positive (zero) abnormal returns
