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.
Two weeks ago, we looked at Facebook which is included in many ESG-themed indices and funds despite corporate governance concerns and a recent data privacy scandal. Some ESG managers even divested from FB following the scandal. Although Facebook is the most recent example, there are divergent views and competing opinions regarding the ESG characteristics of many companies.
A quick glance at some of the largest ESG funds reveals that there is a range of opinions regarding many companies, from JP Morgan to Exxon Mobil to Netflix. Some ESG funds own these names and some do not. We can see this visually by pulling ESG ratings from two different providers for companies in the S&P 500 index. The results (below) are all over the place with a weak correlation. Upon first glance, it appears that ESG factors (like other investment factors, such as quality or value) are in the eye of the beholder.
However, things look much different at the fund level. Below are the respective ESG scores from two large ESG ratings firms for some of the largest large-cap ESG index ETFs. The correlation is much higher and the scatterplot falls within a much tighter range (blue lines). Sure, there are differences in methodology, holdings, and weights, but the aggregate ESG ratings are similar.
This is similar to relationships that we find in the traditional investment world. For instance, value funds weighted by P/E, P/B, P/CF, dividends, CAPE, and so on, may all have different holdings and weights, but they largely share similar characteristics and factor tilts.
Just as investors should not get too hung up on the high level numerical ESG scores or use subjective judgments arbitrarily, it does help to understand the inputs, assumptions, and overall methodology of the ESG ratings. The ESG ratings of individual companies can vary wildly, but a larger portfolio (such as a mutual fund or an exchange-traded fund) will diversify a lot of that variability away (as shown above). However, funds are constructed in a variety of ways and there are both better and worse ESG funds out there, so investors still need to look under the hood to know what they own.
The recent Cambridge Analytica scandal at Facebook has brought up an interesting question for ESG investors: if data privacy had been highlighted as a risk at FB, why did FB have such a high ESG score and why is it one of the top holdings of many ESG funds?
To answer the first question of why did FB have such a high ESG score, it may be helpful to review what ESG is and what it is not.
- Environmental, Social, and Governance (ESG) issues are risk factors and ESG scores cannot predict the future any more than financial metrics like price-to-book (P/B) or return-on-equity (ROE) can. Both financial and non-financial metrics can help investors tilt their portfolios, but they cannot help investors select individual winners and losers.
- Data on ESG factors is collected from many sources with varying levels of quality and completeness. The ESG ratings providers evaluate this data and provide both objective and subjective reporting. Just as investors should not blindly purchase investments with a five-star rating from Morningstar, investors should not blindly invest in something just because it has a high ESG score.
- Identifying risks is only half the battle. Accurately estimating a risk’s probability and its impact is the other half. BP had relatively high ESG scores prior to the Deepwater Horizon oil spill, as did VW before its emissions scandal and FB prior to the Cambridge Analytica debacle. Even though ESG risks had been identified, the perceived probability of the aforementioned events had been too low. That being said, estimating traditional financial risks or ESG risks is difficult (if not impossible) and surprises are by definition unexpected.
- Risk is only one side of the equation. Even if an investor had underweighted FB as recently as a year or two ago, that investor would have missed out on substantial returns. Such a person may argue that FB’s environmental (E) score more than compensated for its governance (G) score. A skeptic may say that the investor deemed the data privacy issues worth returns (especially in light of FB’s private data-dependent ad revenue and the relatively rapid rebound that we’ve seen in its share price from the scandal-driven selloff). Either way, ESG are a set of risk factors to be evaluated, not to arbitrarily exclude/include.
To answer the second question about why FB is a top holding of many ESG-themed funds, it may be helpful to think of ESG funds similarly to how we think about dividends funds or other factor-based funds. For those that rely solely on ESG scores or buy index funds based on ESG scores, it is important to understand how the sausage is made and understand what limitations exist. A familiar parallel may be the dozens and dozens of dividend-oriented index funds, which are constructed using a variety of methodologies. Why are some companies included in some funds and excluded from others? Investors should evaluate how their funds are constructed, what is in them, and decide if it matches their desired exposure. Whether a fund focuses on ESG, dividends, or anything else, I encourage investors to understand how the fund is constructed and what trade-offs exist. The simple answer is that FB is a top holding of many ESG indices due to how the indices are constructed; simply read the prospectus and you’ll discover how FB was included and weighted.
ESG analysis, like anything else in investing, is not easy. It’s a framework for thinking about risk rather than something that can be reduced to numerical score and blindly relied upon. At best, it helps investors make better decisions and incrementally improve the risk/return characteristics of their portfolios.
Don’t look now, but the yield on the 10-year UST is breaking out of a 33-year downtrend. I do not know what this portends, but that trendline is very long and has been incredibly strong, so the breakout is worth noting.
As the president has ramped up his tweeting about America’s trade deficit with China and is threatening a trade war, it is important to remember that running a trade deficit is not a terrible thing. As Warren Buffett noted at the recent Berkshire Hathaway shareholder meeting,
“When you think about it, it’s really not the worst thing in the world for someone to send you things you want and you hand them a piece of paper.”
This is especially true if you print the pieces of paper and the Chinese cannot effectively do anything with that paper besides buy US Treasuries with it. Obviously, there are other reasons that a country may want to produce some good/service domestically (instead of importing it), but eliminating a trade deficit in and of itself is not a great reason. Unfortunately, the word deficit has a negative connotation and so I do not expect this perennial political talking point to disappear anytime soon.
This chart just hit my inbox and is a decent visual representation of last week’s post on why the housing market continues to appreciate despite higher mortgage rates and less favorable tax treatment of mortgage interest and property tax under the new tax law. Ignore the narratives, just look at supply and demand.
Don’t look now, but the SF Bay Area housing market is on fire. A few weeks ago, a burned out house in San Jose sold for $800k and made national headlines. Now my town Fremont is making the news with a CONDEMNED home that sold for $1.23M.
There are logical explanations such as high rents and low rates support such prices and/or the buyers of the two aforementioned properties can tear them down and build a new structure with instant equity. Of course, that equity relies on today’s rates and/or prevailing prices. I’ll make no predictions on the direction of prices, but I will say that the supply and demand of assets often influences prices a lot more than economic fundamentals. This goes for nearly all assets from real estate to equities to fixed-income to cryptocurrencies and so on. For my fellow Bay Area folks, do please try to ignore the various narratives and ex-post rationalizations for why our real estate prices are hyperbolic; we simply have an extreme imbalance of supply and demand resulting from years of underbuilding. This is what an asset shortage looks like. Yes, “asset shortage” typically refer to “safe haven” assets like Treasuries, but when you live in a region where South and East Asian immigrants are the marginal buyer, real estate in a decent school district fits the bill.
Like many Americans, I’ve been saddened and angered by the increasing number of mass shootings in our country. My wife and daughters even braved the rain and hit the streets to March For Our Lives a couple weekends ago. As the activism against assault weapons increases, so are calls to divest from assault weapon manufacturers and distributors. Thus, I believe now is as good a time as any to talk about “divestment.”
Definition: Divestment is the act of excluding a company, industry, or sector from an investment portfolio.
Reasons to Divest
- Many (including myself) practice divestment as a way to align their portfolios with their values. Some investors would rather not receive any investment benefit from the sale of assault weapons (or cluster bombs, chemical weapons, and so on) and so choose not to own companies associated with these products.
- There is also an argument that investing in risky or controversial businesses is risky because risks and/or controversy invites activism which can result in stricter regulations. Just ask tobacco companies or oil drillers.
However, investors should also understand what divestment will not do.
Reasons Not To Divest
- Divestment reduces the supply of capital available to a company which increases its cost of capital. However, there are still plenty of investors willing to invest. So although divestment increases a firm’s cost of doing business, it also increases the returns to that firm’s investors. Cliff Asness of AQR recently summarized this concept in an aptly-titled piece: Virtue Is Its Own Reward: Or, One Mans Ceiling Is Another Man’s Floor.
- Readers may point out that a higher cost of capital and weaker financials should result in weaker share prices and performance. Perhaps in theory, but I have not found the weight of empirical evidence compelling.¹
- Divestment campaigns have not been shown to be effective historically, except to the extent that they are a means for social and/or political stigmatism. William MacAskill (a leader in the “effective altruism” movement) asks and answers the question: Does Divestment Work?
- Not only is divestment unlikely to hurt a firm’s shareprice or investors, it is unlikely to benefit those who divest. Excluding a miniscule industry like firearms manufacturers will make no discernable difference to capitalization-weighted investor. Excluding larger industries or sectors may result in increased tracking error versus a benchmark, but is unlikely to make a material difference over a multi-decade timeframe as most sectors mean revert to the market over time.² I’ve found most arguments otherwise are timeframe dependant (ie. just changing the starting and ending dates results in different outcomes).
- The upshot is that if divestment will not make a major difference to an investor’s portfolio, then investors can also capture market rate risk and returns without many (if any) tradeoffs.
- Investors that own funds may find it expensive to divest if they have unrealized capital gains. Rather than divest and pay tax on the capital gains, it would arguably be more effective to donate an equivalent amount to an activism campaign.
Divestment is one of many tools that investors can utilize to align their portfolio with their values and/or effect change. Other options include:
- Underweighting or otherwise optimize their exposure to objectionable companies, industries, and sectors. Kind of a “divestment-lite” approach.
- Maintaining exposure to an industry or sector, but only invest with the most responsible or “best in class” firms (perhaps those that are pivoting away from the objectionable business).
- Maintaining ownership of shares in order to engage with management through voting proxies and/or bringing shareholder resolutions. Sometimes having a seat at the table is the most effective way to effect change.
- Invest in companies that counteract the problem or solutions.
Divestment can be a great tool to align portfolios and it is something that I personally practice. Like anything else though, investors should consider their goals and objectives to ensure that divestment is the right approach for them.
²http://www.nepc.com/insights/fossil-fuel-divestment-considerations-for-institutional-portfolios & https://www.mayorsinnovation.org/images/uploads/pdf/FINAL_Revised_NorthStar-Cost_of_Divestment.pdf
“Painting is easy when you don’t know how, but very difficult when you do.” -Edgar Degas
My daughter took a climbing class and now we go to gym regularly to climb. In the beginning, I’d yell up to her from the ground: “Good job!” “Grab that red hold!” “No, put your foot on THAT blue one!” “Just grab that hold to your left!” She was generally reticent to take logical routes, which I chalked up to her cautious personality and young age.
Then one day, I put a harness on and got on the wall. From the ground, my daughter yelled the same things at me: “Dad, just grab that one!” I thought, easy for you to say from down there! “Daddy, just reach up to that yellow one!” Again, I thought: Yes, technically, I could do that, but I’m not sure I can reach it, it feels uncomfortable, it feels risky, and so on.
Doing something is often harder than knowing how to do it. I believe recognizing this encourages understanding and humility, which in turn helps to distinguish between reasonable and unreasonable expectations, criticisms, and so forth. Some may think such an approach is simply a lowering of standards, but I see it as providing a more realistic view of reality which leads to a better estimation of possibilities, probabilities, and ultimately better decisions and outcomes. The implications for due diligence, allocating, and investing in general are too many to count.
“In theory, there is no difference between practice and theory. In practice, there is.” -Yogi Berra
During the PyeongChang Olympic Games, my four year-old daughter and I were watching skeleton (like luge, but headfirst and a sport I didn’t even know existed, previously). The athletes take turns going one at a time on a track, similar to the luge and bobsled events. It is impossible for an amateur like me to tell whether someone is fast or slow, except for the on-screen stopwatch that compares the current run to the fastest time. In the midst of one run, I commented “She is so slow!”
My daughter asked, “Why does it look like she’s going really fast?”
“Well, you’re right, she is going really fast. Really, really fast. She’s just like the seventh-fastest in the world instead of the fastest in the world,” I replied.
It was a simple reminder that context matters and that consumers of financial media (or even this blog) should assign very little weight to what is said and written about a great many things.
A financial analog to the above skeleton story are people saying they want to invest in stocks because they heard bonds are risky or crytocurrencies because “fiat” currencies are not a reliable store of value. Obviously, I’m not against investing in stocks or cryptocurrencies or anything else, but the preceding statements are ridiculous. Otherwise reasonable people say these things because they did not understand the context of something or do not appreciate magnitude of risks being described.
As Nassim Nicholas Taleb writes in his newest book “Skin In The Game”:
Don’t tell me what you “think,” just tell me what’s in your portfolio.
Most investors would probably be well-served to adopt Taleb’s approach. Having listened to a zillion sales pitches and investor calls, I can confidently say that what people say and do can be very different.
Consider a portfolio manager (PM) who is bearish, which is typical of fixed-income PMs. The PM may hop on an investor call and share some doom-and-gloom economic data, opine about the ineptitude of fiscal and monetary policymakers, comment on market risks, and so on. Yet, all of the preceding is likely general in nature and may have nothing to do with the portfolio holdings, not to mention vehicles used to gain exposures or positioning/views within capital structures. Additionally, PMs tend to think and act probabilistically, so position sizes, correlations, and expected return scenarios matter too. Lastly, opinions can change on a dime and investors can act in a way that seems opposed to their beliefs.
As an example, someone can be both very bearish and still invest:
- because they accept that they can be wrong, don’t believe that the market can be timed, or are averaging down.
- less aggressively than maybe they otherwise would (the same reason banned-from-baseball Pete Rose cannot be excused for only betting on his own team).
- with a different risk/reward profile by managing their risk exposures, greeks (in options-speak), and so on.
Oftentimes, I recognize and respect some particular risk, but will invest and expose a portfolio to it if returns more than compensate for the risk, favorable convexity can be obtained, or a number of other considerations. Risk is hard to understand without an idea of probability, possible scenarios and consequences.
All of this is to say that when listening to an opinion, investors better understand precisely what is being communicated and what is not being communicated. General prognostications and/or commentary on specific risks are meaningless without an understanding of context, positioning, as well as expected probabilities and payoffs.