For us researchers, a question we’re asking of the asset classes we cover is: what can be done? Much ink has already been spilt on ESG in other major asset classes, though less on systematic risk premia strategies, and less again on outcomes geared towards climate risk. So is the integration of ESG or climate risk (focusing more specifically on the “E” in ESG) the height of greenwashing, or is it actually possible to invest in this asset class if you care about climate risk?
What is Risk Premia investing?
Risk premia strategies invest in trading strategies that exploit long term risk/return sources across asset classes. Implementation is through automated systems and trading strategies that require, but do not rely on, human input. While very few risk premia strategies are the same, common sub strategies include equity style, trend following, merger arbitrage, risk parity and carry strategies, amongst others.
Where were we?
In our recently completed review of risk premia strategies, an early stage RFI included a question on ESG integration. I have used a little author’s license to classify (and shorten) the answers to this question into 4 broad categories. These are fairly self explanatory, maybe with the exception of the last; managers who had thought about ESG integration, but did not find it additive to performance, are classified separately to those who had not thought about it at all. As the chart shows, less than half (44%) the managers who responded did not consider ESG. You’d be forgiven for thinking this is not the strongest start if you care about climate risk; it is as if half the sprinters in the race have stumbled out of the blocks.
What is possible?
We took research meetings with managers that fell into all four of these categories. Presenting us the chance to hear both sides of the argument and to see what is – and isn’t – possible in risk premia.
Let’s start with the good news. If climate risk, or ESG factors, have an effect on the long term performance of companies (which is becoming – has become? – consensus). Then logic figures that it is preferable to integrate ESG into parts of the portfolio holding positions in single companies over a time frame where these inputs can materially effect a company’s value. Positively, we found that managers seem to have found some low hanging fruit here; widening the scope of negative screens to more vigorously exclude companies that are overly exposed to environmental or social risks, so moderately tilting the portfolio from an ESG perspective. Some have looked to take this further by focusing on the carbon intensity of a portfolio, and tilting the long-short portfolio towards companies with lower carbon footprints, all things equal. Therefore, improving the risk characteristics of a portfolio from a carbon perspective.
Other conversations have been focused on the integration of ESG signals into the quantitative models that forecast risk and return. These signals have been added after a research process, in much the same way as the addition of “normal” signals. The addition of ESG signals is a step beyond the screens, as the development of a company’s ESG, or better still, carbon profile, will affect its risk/return forecast and ultimately its position size through time. It is a step beyond negative screens because it moves beyond risk management and begins to address the systemic issue – that companies’ actions affect climate change. The implementation of the equity style component via cash equities and increased quality of available data has made this possible. The runners’ poor starts have improved.
Now the not so good news. The number of positions (500 – 1000+) and the small position sizes (<1%) within equity style portfolios mean that active engagement is difficult relative to fundamental equity managers – so influencing companies by this strategy alone is not possible. What’s more, the equity style component is also combined with risk premia that are macro by nature (trend following for example) and are implemented through macro indices. Here arise two problems that mean incorporating views on carbon risk is difficult. First, there are philosophical arguments. Should one go short coal to drive down profits for companies dependant on coal revenues, or long, to increase the price and therefore make renewable alternatives better value? (In fact, the recent oil market slump and the outlook for oil companies now is a ready made case study for this question!). Second, there are implementation difficulties. Trading volumes on green indices are insufficient to support the level of trading required by these sub strategies and futures do not provide any voting rights. The thought process becomes even more complex when one combines sub-strategies too; if you are short 1 or more of the oil majors in the single name equity portfolio, but long the FTSE 100 in the trend component, then is one helping, or not?! These are conversations we continue to have and – if you are still reading, thank you – I would be very interested to hear your views.
Do asset managers want to make progress?
Where have we got to in the answer of our question? Well, by my count, the answer is positive, but the applause is not yet rapturous. Which leads me onto my final, and in some ways, most important point. It has become quite apparent that many of those responsible for managing these strategies, including our “Preferred” managers, want progress. As a result, the rate of change in this area, even over the last 6 months, has been pretty remarkable. Though, as always, the proof will be in the pudding. Once the low hanging fruit has been picked, will innovative solutions for the more complex parts of these portfolios be found?
Can you invest in risk premia if you care about climate risk? Sure, you can, though it won’t change the world, yet.