Written By: Steven Winter – Corporate Finance
Institutional investors are struggling to raise yields and are seeking the niches that can balance risks with yields. Faced with renewed volatility, growing risks and a persistent weakness in returns, institutional investors are increasing their exposure to riskier assets in order to improve the performance of their investments. At the same time, they are redoubling their efforts to optimize risk management in order to find a better balance between their growth objectives and their long-term liquidity requirements. They also need to find better ways to understand the risks inherent in their portfolios.
Natixis Global Asset Management recently published its annual survey of 500 institutional investors from five continents, collectively managing a total outstanding of $15.5 trillion. This survey confirms that management teams are placing increasing emphasis on environmental, social and corporate governance (ESG) criteria. They believe that they can identify companies and investment trends with ESG criteria that can sustain the growth of their portfolios over the long-term.
This trend is accompanied by another trend illustrated by the Natixis survey: Nearly 75 percent of institutional investors believe that current market conditions are more favourable to active managers; their exposure to passive strategies has decreased. While by 2015, 9 percent were planning to increase their exposure to passive strategies over the next three years, those who are has dropped to only 1 percent (by 2019). When comparing the relative benefits of active and passive management, 86 percent of respondents stated that the former makes it easier to generate alpha (over-performance compared to the related index) and to balance risk and performance; and 75 percent estimated that it facilitates the investments in assets with ESG criteria. Another interesting point raised by the study is that according to institutional investors, retail investors are looking mainly at index-performance comparisons and forgetting the underlying risk of index management; they have a false sense of security.
But ESG criteria can help balance performance and risk; ESG indexes not only beat general indexes, but there is a study proving that integrating ESG criteria can also contribute to decreased risk in a portfolio. There are examples in which the performance of the index integrating ESG criteria outperformed its related global index. For instance, the MSCI Emerging Markets ESG Index is a capitalization-weighted index that provides exposure to companies with high environmental, social and governance performance relative to their sector peers. MSCI EM ESG consists of large and mid-cap companies across 23 emerging-markets countries. What is also interesting is that the beta (volatility) of the MSCI EM ESG, at .94, is lower than the beta of its peer MSCI Emerging Markets Index, at 1.0. In terms of risk, investments integrating ESG criteria have proven to bear less risk.
Indeed, a study carried out by the American asset manager AQR Capital proves that ESG information can be a valuable source of information on the level of risk of a company’s securities. In a recently published study entitled “Assessing Risk through Environmental, Social and Governance Exposures”, AQR reports that “securities with low exposure to ESGs tend to have higher total and specific risks and higher betas, both immediately and up to five years…. We interpret these results as evidence that ESG information can play a role in investment portfolios that goes beyond ethical considerations and that can inform investors about the degree of risk of securities in a complementary fashion to what can be captured by traditional statistical risk models”. The authors highlight that among the three ESG criteria, the pillars of social and governance have the strongest correlation to risk.
Demand is pushing the market for more data on ESG. Recently State Street’s report entitled “Investing Enlightenment: Principles and Pragmatism Can Create Sustainable Value Through ESG Investment” revealed that 92 percent of the institutional investors surveyed wanted companies to explicitly identify ESG factors that specifically affect performance. Traditional barriers to investment meeting ESG criteria are gradually disappearing. The percentage of institutional investors who believe that ESG investment is detrimental to performance continues to decrease—it is now 31 percent among EMEA (Europe, the Middle East and Africa) institutional investors. Lack of data to identify ESG criteria is mentioned as the main factor slowing down the development of investment in companies with ESG criteria. But no doubt the market will progressively meet this need.