Climate Change 2011 Part 5 - Exploding the underperformance myth

Lars Kalbreier

The feel good factor must be correlated with the performance in the long run. Otherwise we would be a charity

Andreas Knoerzer

Doing well by doing good. That would be the perfect world.

Regarding the whole performance question, this is a question that we are currently discussing for large clients. Does it naturally bring an underperformance or an out performance? I always have two slides when I give a talk, and I call that the multi-million dollar question. And the only thing I do is write down all the links to all the studies available published over the last couple of years. And then I say, ‘Okay, that is the work of the smart people in the universities, and now, let us talk about the real experience.’ At the end of the day, what we have to do is provide evidence that the real performance is okay. Therefore, I am a fan of start doing things. Just do it, start to build up the track record. There is even a chance of having a strong outperformance in my believe.

Lars Kalbreier

I think targeted thematic funds do well and tend to, in some cases, outperform the benchmark. So, instead of having to invest in the whole investment universe, you can really focus on and target much juicier bits. In fact, at Credit Suisse we have a core satellite approach, where in the core part, the focus is close to the benchmark and general markets. In the satellite part, the juicier bits are very much in the targeted thematic approach. Now, if you look at SRI as a whole, and if you just base yourself on sustainability criteria all of our back listings have shown that it is very difficult, from a statistically significant level, to show that high scores from an SRI perspective lead to outperformance – in 2006, we started doing a partnership with Innovest, a large sustainability ratings agency which rates more than 3,000 stocks on sustainability criteria. If you look at the t statistics and the tests you have, it is very difficult to make that argument. So, if you are talking in terms of the general market and you only invested around sustainability criteria without having this targeted thematic overlay, then it would be very difficult to make that case. That is why if you are really after alpha, you cannot invest using only sustainability criteria. You need to marry that with other approaches, which are more targeted.

Viktor Andersson

The Goldman Sachs Sustain approach basically proved that if you are in the top quartile on sustainability then you have higher sustained profits than if you are in the other quartiles.

Lars Kalbreier

Well, the interesting thing is, in the discussions that I had with them over many years, there was no suggestion of robustness in the back testing, implying that there was a significant outperformance.

Carlos Joly

My experience over 20 years, having initiated and implemented various approaches to integrating environmental, social and governance factors in investment management is that a mistake that is repeatedly made in the discussion as to whether there is outperformance or not, is to start with the assumption that there is an asset class in itself that guarantees outperformance, an asset class that is somehow defined by sustainability criteria. But that is no more true than the proposition that doing value investing will outperform or doing income investing is going to outperform. So much has to do with the quality of the investment process and so much has to do with the talent of the asset manager. A lot has to do with the geographic distribution and a lot has to do with currency, nowadays. You might find that the currency factor is very important to the performance, so simply to say that, ‘Does sustainability approach perform or outperform, per se?’ Is a false positing of the issue. I think what one can safely say is that in the hands of a competent asset manager, there is no reason why a sustainability approach should underperform. Consequently, the outperformance that using such an approach can create is based on the quality of the research, the quality of the portfolio manager and the quality of the investment process.

Elisa Trovato

How do you implement the integration of ESG factors into the investment process? What are the factors that you look at when you screen the stocks? For example, there is a concern the universe of investable stocks become too restricted when screened against sustainability criteria, so that would impact performance.

Viktor Andersson

If you create a plain vanilla SRI fund, you want to limit the universe. You want to differentiate it, based on ESG factors, from the non-SRI universe. That is the whole purpose. You need to separate SRI from ESG integration though, with ESG integration being much more interesting, where you try to find the key three or four value drivers per industry, and make the portfolio manager have ownership of them and then integrate it properly into investment decisions. Changing the way the investment managers look at their holdings is integration, not screening out certain companies or industries, albeit across all portfolios.

So for SRI funds, you can just create your matrix. You start with the universe and then you put some kind of barrier that states that they have to have a certain degree of awareness and management systems etc in place in order to classify for a SRI portfolio. Then you add what you feel is important from a value creation perspective, like thematic approaches or maybe integration as well, to help guiding you to an interesting portfolio. The wider ESG integration covers all portfolios and all asset classes, the trick is to pinpoint the relevant ESG factors.

Elisa Trovato

Do you think ESG integration has become mainstream?

Viktor Andersson

No, it is not mainstream, although it will be. It is heading there. The Eurosif study and the equivalent studies for the Nordic indicate that 80 per cent or so of the assets have integrated ESG, but I would say that they have not. In order to do proper integration the portfolio manager has to be able to say, ‘For this particular company, e.g. Siemens, in what way is sustainability integral for the business model of the company? Why are they making money? Which sustainability factors are they making how much money from?’ This would obviously impact the valuation.

Very few players have the skills to do that today, even on a global scale.

Very few players do that today, even if you look at the global perspective.

Elisa Trovato

Are sustainability factors priced into a company’s asset evaluations?

Viktor Andersson

Not in general. If they were, there would be no point in doing an ESG integration, and there would be no business case for it, and I am absolutely convinced there is one.

Matt Christensen

It’s hard to, because it goes back to measurability and accountability. How do you assess that across companies and sectors?

Elisa Trovato

So what are the advantages of integrating ESG factors into an investment process?

Viktor Andersson

I think you get a more accurate, more fair, value of the company. If you do it properly then you will get a more correct valuation of the company. That is what it boils down to.

Joost Bergsma

I think it is an evolution, rather than a revolution. So that means we are on a path that has started maybe ten, 15 years ago, that will last probably at least another ten to 15 years, and we are half way or maybe we are a little bit further than that. But, I think it is very clear, and I think most people would agree from hearing what I have heard so far, that ESG will become fully integrated into a corporate way of doing business, in the same way that safety is paramount in an airline. It is there and corporates do it, and comply with it. I think there is something to be said for the fact that if corporates are further advanced and leading in ESG criteria, they will probably get to that end point faster, and hopefully that will lead to outperformance. One comment I would make on performance is that I think it is clearly important that we have demonstrated to investors that the performance is there, but at the same time, performance expectations change over time. I do not think that in today’s post-financial crisis, investors are looking for the [highest risk / highest return best] performance. I think they are much more risk-return driven. That is why we have been successful in building on thematic funds to look for steady income type performance and, ‘don’t lose me too much money,’ type performance. There is a different paradigm today than in, perhaps, a bull market. So products have to adapt to that. And that is why I think thematic funds that have a slightly different risk-return profile and have more income driven type performance, as opposed to being in the top 3 per cent, are a much more appealing types of products, today.

Andreas Knoerzer

Regarding performance, I agree with Carlos. Of course, there are so many other drivers of performance which have to be taken into account. But that is ensuring practice, really. The way it works is that clients as well as consultants - who are really driving the institutional world nowadays - asked us whether we could assess that screening from the general market down to the sustainable universe actually adds to performance. So, that is a part of the attribution, because it will bring a different starting point from where the portfolio manager can do his job, for instance, looking into currencies sector weightings or country weightings. So, there is definitely a need to make sure that this is not a starting point because that would be negative. You would have to overcompensate that. So consultants and even customers are now starting to ask the question, ‘What is the pure assessment of the company, with the screening in and out, adding to the performance?’ And from there, obviously, all the other issues under our important criteria have to be taken into account.

Matt Christensen

I think the beauty of this conversation is that the diversity in this field still always hits me from so many angles. It is its own Rubix cube. The very quick answer to the question, ‘What does ESG integration add’ - potentially, risk minimisation; potentially, better performance returns over time; potentially, identification of future opportunities; and potentially, anticipation of future ESG regulation costs.

ESG integration has certainly become more mainstream over the past five years, but this is still early days in the growth of this sector. It might be helpful to compare it to where hedge funds were twenty years ago - the hedge fund industry was struggling in Europe with how to define itself, aside from their typical fee structure of ‘2 plus 20’. There were many questions about the how to distinguish a hedge fund such as , ‘merger arbitrage’ versus ‘macro’ versus other areas? Over time however, it has become much easier to categorise a certain type of hedge fund.

I believe that a similar phenomenon is occurring with ESG integration. Over time, investors will specialise in the type of ESG integration approach they utilise. Related to ESG integration, you will increasingly here things like: ‘I am an impact investor or I am a thematic investor across these asset classes.’ I think the conversation around performance and around what ESG is and how to define it, is going to actually become more granular based on the specific investment approach. I can see it happening now over time, as categories start to be created and understood so that interested customers can actually say, ‘Let us speak about what you as a fund manager actually do in that sub category of ESG integration.’

Carlos Joly

I would like to try to specifically answer your question, ‘What does ESG integration add?’ So, let me suggest that you take two companies in the same sector and imagine you are a portfolio manager looking at two companies. Which one of the two should you have in your portfolio? They have similar balance sheet strength, they have similar price earnings ratios. If you look at purely financial characteristics, they are very, very similar when you look at their financial ratios and at their financial performance. And then you ask yourself, ‘Well, does one have a clear strategy to reduce carbon dioxide emissions? Does is have a clear strategy to reduce water waste? Is it creating lighter products that will require less cost and space in transportation and doing it with less packaging for less waste? Does it understand the regulatory world better? Does it have a better environmental management system inside of the company? Is it developing new products, for instance, to address climate needs, either on mitigation or the consequences? Take a steel company, for instance. Is it developing lighter steels of equal tensile strength? Or take a cement company. Is it producing cement with 70 per cent use of energy compared to its competitor? Those are the kinds of questions that an ESG analysis flushes out. And if you find two companies with roughly similar financial characteristics, but on these ESG characteristics one is notably better, then you can make the reasonable assumption that it will perform better in the future than its competitor, because it will tend to have greater product acceptance and will tend to lower its operational costs. And then you choose to invest in that one. That is the clear reason why one does go through the extra effort. That is a sufficient difference in itself, and I think it is a difference that investors understand.

Elisa Trovato

If companies that operate in a sustainable way are bound to perform better, why are there not so many of them? Is there a way to incentivise companies to operate in a more sustainable way?

Lars Kalbreier

I think we are in the midst of this evolutionary process. Right now, sustainability is a factor amongst many other factors. You can look at arrangement, you can look at valuation and you can look at many different things. The more investors start to incorporate ESG factors in the screening, the more you will have a link between valuation and paying a premium for companies that are good at ESG or paying a discount for companies that are bad at ESG. So, we are on a journey, but we are not there yet. Many pension funds are now starting to be more receptive to the idea, and are building that as one of the criteria which they are using in their investing. Ultimately that will then be reflected in valuations.

Steve Triantafilidis

I think more and more companies are taking it seriously and company CEOs that we meet are willing to discuss the topic much more than in previous years. The BP Macondo disaster was a wake-up call for a lot of companies in different industries of what potential impact something like that has on the company’s rating and their market cap loss, when you are not properly addressing some of the issues. On the point about pension funds, I recently read an anecdote about Unilever doing a presentation and being disappointed that more questions were not being asked about what they were doing in sustainability, in particular because they had a long track record of showing that they were sustainable. A question from the audience came: ‘What is your pension fund doing on this topic?’ And the company management did not know the answer. So I think for myself and the audience, they lost a lot of credibility when they have a pension fund that is not incorporating these issues in their assessment of investing. On the other hand, the company is saying that investors should be more active in this area.

Carlos Joly

The problem is, they knew it, and they just did not want to say. They knew that the answer was ‘no’. And to point to the irony, if you look at the World Bank’s pension fund and the United Nation’s pension fund, and the dissonance between the ideology of the organisation and the actual investment behaviour of the portfolios of their pension funds, it as if they were in two different universes. So, it is not just the private sector that has that disconnect. You find that disconnect at the World Bank and you find that disconnect at the United Nations and in public government funds. So, in a very interesting way, it is curious, and perhaps it is a hopeful sign, that the ones who are at the forefront of actually making it happen are the private investment managers.