Has the yield curve lost its predictive mojo?

Crikey! I’ve lost my mojo!” –Austin Powers

Former Fed Chair Ben Bernanke recently joined the chorus of voices casting doubt on the predictive ability of the yield curve. Yet, others such as Minneapolis Fed President Neel Kashkari, have been quite vocal about the risks of inverting the yield curve.

Whatever your views on Bernanke, Kashkari, or inverted yield curves, it would be wise to understand that the top policymakers disagree on the topic. Nobody knows how predictive the yield curve still is. Only time will tell. In the meantime, we should approach the debate with humility and understand the opposing lines of logic thoroughly.

Happy Friday!

Yield Curve Inversions

As the yield curve continues to flatten, there has been increased focus on the potential for “inversion” which means that short-term rates are higher than long-term rates. Central bankers have begun mentioning it, we have seen an increase in media mentions, and we have even received a few questions from clients. Below is a chart of the difference between the 10-year US Treasury yield and the 2-year US Treasury yield. The 10-year yield is usually higher than the 2-year yield, but short-term rates surpass long-term rates every now and then. Historically, these inversions have occurred prior to recessions (as indicated by red vertical bars).

A few observations:

  • The yield curve may very well invert, but has not inverted yet. The curve almost inverted in 1994, but did not and the next recession was not until 2001.
  • The recessions charted above have began 12-24 months after the curve first inverted, while it was nearly 3 years after the 1998 inversion.
  • With rates at historically low levels, there are good reasons to doubt that a flat or inverted yield curve is as predictive as in the past. We have our opinions, but it always pays to see multiple sides of an issue and no indicator should ever been overly relied upon or used in isolation.

The above being said, we do not think that the yield curve is indicating an imminent recession. Of course, the shape of the yield curve does have implications for risk/return dynamics and portfolio positioning and investors should adjust accordingly.

Parenting 101

“Do you have any financial advice for new parents?”

A handful of friends have asked me this question in the past week. The question often relates to childcare expenses or college savings plans, but I usually advise new parents to prioritize the below items before anything else. My typical advice sounds something like this:

  • “Buy enough term life insurance to provide for your family if you and/or your spouse die prematurely. There’s no “right” amount, so ask yourself what you would want covered if you passed. Your salary of x years? Your spouse’s salary so he/she wouldn’t have to work for y years? Childcare expenses for z years? Payoff a mortgage? College tuition? Other expenses? Add those numbers up and go get some quotes.
  • “Establish an estate plan, including a revocable living trust and will. The will should appoint a guardian for your children if you pass away while they’re still minors, although the courts do have the final say. The will also directs what to do with assets that were excluded from the trust (or forgotten to be put in the trust, which I have seen several times!). The trust should help avoid probate for assets placed within it and provide for supervision of the assets for the benefit of the children.

Unfortunately, the above is often news to new parents. However, both of the above can be one-time decisions, which is a relief for most new parents who are completely overwhelmed with the chaos of parenthood. Neither action is free, but the reduction in risk is well worth the expense IMO.

An extra disclaimer this week: The above is educational and describes advice I have given others, but is not legal or financial advice for readers. Every situation is different and I’m not an insurance agent or an attorney. 

Case Study: Core Civic

Related to my recent post on the ESG risks of private prisons, the United Nation’s Principals of Responsible Investing (UNPRI) recently highlighted Core Civic in a case study on credit risk.

Summary: https://www.unpri.org/credit-ratings/credit-risk-case-study-corecivic/3261.article

Full paper: https://www.unpri.org/download?ac=4944

ESG Watch: #familiesbelongtogether and Private Prisons

The #familiesbelongtogether rallies that took place across the country yesterday are inextricably linked to the for-profit prison industry and may even be connected to your investment portfolio.

Private prisons operated by for-profit companies have been controversial for quite some time, due to subpar safety records, higher costs (which is theoretically their primary benefit), and perverse incentives. Despite consistent criticisms and litigation against them for the aforementioned issues, they may begin to attract even more scrutiny, since the majority of immigrant detainees are held in private prisons.

The recent policy of separating children from their parents at the border was deeply unpopular (and quickly reversed) and I am guessing this will put an even greater focus on these for-profit prison companies. Although the publicly-traded operators Geo Group and Core Civic are included in the major benchmark indices, many responsible indices and investment managers already exclude them. While the stocks are up quite a bit since Trump’s election, negative press and litigation could escalate and convert a social values issue into shareholder value issue.

UPDATE: Trade-offs: High Level ESG Scores vs Specific Tilts

An important correction/update to my last post.

Source: Bloomberg

Upon further analysis, I found that the low-emission portfolio’s overweight to companies with bottom-decile ESG scores was the result of including companies with no ESG scores. The above chart has been updated to only include holdings with an ESG rating. As you can see, the result is that the low-emission portfolio scores very similarly to its benchmark. This illustrates that investors need not sacrifice ESG qualities to materially reduce emissions exposure. On the other hand, the portfolio still has benchmark-like ESG scores, rather than broad improvement. Thus, I believe the main point that investors must prioritize what exposures they want (it may be impossible to target a portfolio with high ESG scores, low emissions, gender diversity, and low tracking error) still remains the same.

Trade-offs: High Level ESG Scores vs Specific Tilts

6/27/2018: IMPORTANT UPDATE AND CORRECTION TO THE BELOW HAS BEEN POSTED HERE: http://thoughtfulfinance.com/2018/06/27/update-trade-offs-high-level-esg-scores-vs-specific-tilts/

Now that we have looked at how ESG considerations and index construction methodologies can impact the ESG characteristics of indices, it is time to delve deeper into specific issues. For instance, rather than optimizing high level ESG scores, an investor may want to primarily optimize the environmental (E) and governance (G) scores without regard for the social (S) score. Or an investor may want to focus on more specific or objective issues such as lower emissions or gender equality. Again, we will be looking at a single fund that is well-known, tracks a well-known benchmark, and is sufficiently scored by a well-known ESG analytics firm. Not comprehensive a study, but illustrative of some basic dynamics.

This particular fund targets low greenhouse gas emissions and avoids owning fossil fuel reserves, while also divesting from stocks with severe controversies. The emissions metrics look great as shown below:

Fund Benchmark
Tonnes of CO₂ per $1M invested 37 103
Tonnes of CO₂ per $1M of sales 58 206

Source: Bloomberg, FossilFreeFunds.org

However, the fund’s distribution of ESG scores tells a different story, as shown below:

Source: Bloomberg

The fund (green area) is overweight companies in the lowest-scoring decile of ESG scores and underweights nearly all of the better-scoring deciles (relative to its benchmark index, the red area). Thus, this particular fund appears to achieve its emissions goals at the expense of its high level ESG score. What is an investor to do?

Some investors may want to take a balanced approach and modestly improve the high level ESG scores of their portfolio. Other investors may want to focus more on emissions or gender equality or some other issue, using a fund like the one above. It is also possible to act in a more nuanced way by blending the two approaches, although this can be difficult with the existing universe of ETFs and mutual funds. A word of warning to do-it-yourselfers though: consider the above tradeoffs when constructing a portfolio, as bolting together different funds could result in unexpected exposures (ie. a low carbon fund might more than offset the positive ESG characteristics of an ESG-optimized fund).

There are no perfect portfolios. Just as traditional investors must prioritize returns, risk, volatility, liquidity, and so on, ESG investors must prioritize what factors are important to them. There is no “right” way to invest, nor is there a “right” way to invest responsibly. Investors must determine what is important to them and then decide which trade-offs they are willing to make.

ESG Approaches: Divestment vs Best-in-Class

The below comparison is obviously not a comprehensive study or representative of the many inherent nuances, but I do believe it illustrates something that I frequently find when evaluating off-the-shelf ESG investment products (such as mutual funds and ETFs). Below are two large-cap index ETFs from the same sponsor using the same ESG rating provider.

  • The first fund (orange) screens out a minimal amount of industries and then weights companies based on their respective ESG ratings.
  • The second fund (grey) screens out a much larger number of industries and then simply weights the remaining funds by market cap.
Source: Bloomberg

The distributions look pretty similar. The first fund (orange) primarily shifts allocations from decile 10 towards decile 8. Is this materially different or better than the second fund (grey)? I would argue no. The mode, median, and mean may look different, but the underlying scores are not necessarily better or worse. Here’s the same data graphed in a different format:

Source: Bloomberg

I’ve looked at many SRI/ESG index products that use various screening and weighting methodologies, but I have not found major differences in the distribution of ESG scores between funds that take an exclusionary approach versus the ones that take an optimizing approach. The net effect of either approach is basically to shift the quality of ESG factors to the right. There may be minor differences around the edges, but I have found the distributions to be largely similar. Again, this relates primarily to index-based strategies.

What does this mean? It means that there are multiple approaches to improving the ESG characteristics of indices. Excluding the “bad” stuff or simply underweighting it often produces similar results. Both approaches can shift a distribution of ESG rankings similarly. Investor motivations, constraints, and objectives will determine the best approach to take (and I don’t advocate one over the other). Ideally, investors can integrate both approaches, although this can be a bit more difficult to execute well.

Integrating ESG into Index Investing

Two of the main arguments made by ESG advocates are that  “values can impact value” and “ESG factors correlate with better corporate financial performance.” I’m sympathetic to both arguments, although they both seem better suited to an active management context (due to higher levels of portfolio concentration and greater emphasis on fundamental analysis). Yet, as investors increasingly shift assets from active to passive, it is worthwhile to examine how ESG considerations impact index characteristics.

The below is not meant to be a comprehensive study, but simply illustrative of what investors can expect from a plain-vanilla ESG-oriented portfolio. The red area (below) represents the distribution of high-level ESG scores (from a well-known ESG analytics firm) for the portfolio of traditional large-cap index fund. The green area represents the same distribution, but applied to an ESG-themed large-cap index fund that optimizes for ESG score.

source: Bloomberg

This particular fund is fairly representative of many ESG-themed funds and receives good high level ESG scores from multiple ratings firms. While the distribution is shifted meaningfully to the right, it is still a relatively modest shift. This is not meant perjoratively as radical shifts often result in unacceptable risks and/or tradeoffs.

Below is the same data in a different format, but with the same conclusions: there is a slight shift of weighting from companies in deciles 2-5 towards companies in deciles 8-10.

source: Bloomberg

When investors are optimizing for high level ESG scores, it is important for passive ESG investors to understand the above dynamics and to maintain reasonable expectations in terms of objectives, portfolio characteristics, and performance. This is especially true when considering the uncertainty surrounding high level ESG ratings (see here and here), the increasing amounts of “greenwashing,” and questionable claims from some sponsors and managers.

Correlation of ESG Scores From Different Providers [One More Chart]

Recently came across the below chart, which illustrates the weak correlation in company-specific ESG ratings from different providers (which I wrote about earlier this week). Even though the below uses slightly different data sets than my previous post, the R² is remarkably similar. I’ve heard other experts reference correlations in .3 to .4 range, which seems consistent with the below and my previous post. I believe the takeaway is the same: the scores are directionally similar (the below dots generally move from bottom left to upper right), but the correlation is relatively loose.

source: Sustainable Brands (via https://www.slideshare.net/sustainablebrands/rising-waves-the-second-generation-of-esg-metrics-and-a-movement-toward-bringing-dark-data-to-light)