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Is ESG investing profitable?

Is ESG investing profitable?

Sustainable Investing

Some say they are not. Let’s take a look at Pension Funds & ESG!

ESG investing has come to our attention not only because of the enhanced return and reduced risks to the portfolio but  also due to its impact on people, planet, and profits (three bottom lines, or TBL). To add value to the TBL, we would like  to explore opportunities in portfolios with ESG integration, coupled with our active engagement to improve investors’  ESG performance.

Pension funds, as asset owners with the fiduciary duty to their beneficiaries, should aim to maximize  long-term investment returns without undue risks, taking into account our impact on the environment, society, and  corporations.

With ESG issues taken into consideration, we believe we can bring along extra value beyond financial returns. 

In recent years, ESG investing has developed from a niche concern to increasingly widespread attention. Signatory  numbers of UN PRI have increased 28% year-on-year to 4902 signatories by March 31, 2022, bringing total investor  signatories’ AUM to an estimate of US$121.3 trillion (UN PRI, 2022). As a commitment, these signatories have been  encouraged to employ ESG factor analysis to enhance returns and manage risks. According to CFA Institute (n.d.), 100%  of 976 institutional investors and 77% of 3588 retail investors being surveyed are either interested in or already using ESG  strategies. Having said that, we believe that it is still a relatively new sector due to a lack of ESG data, investing skill sets,  and experience. Therefore, we believe there is potentially a great opportunity within that. 

There are currently several mature ESG indexes established for investors as benchmarks or investment universes. The S&P  500 ESG Index is a broad-based, market-cap-weighted index that uses S&P DJI ESG Scores for constituent selection while  maintaining similar overall industry group weights as the S&P 500 (SP Global, 2022). We decided to construct our ESG  portfolio based on this index in order to get a diversified equity portfolio with relatively higher ESG performance.  

The Thematic View & Our Investment Decision 

With our belief in ESG investing, we hold the view that the generation of long-term sustainable returns is dependent on  stable, well-functioning and well-governed social, environmental, and economic systems (Clarisse & Thomas, 2021). 

We primarily adopt a best-in-class investment approach to select higher-ESG-ranking firms across industries so that  sectoral diversification is maintained. However, this approach may lead to the inclusion of low-ESG-performing firms  when they are relatively better than their peers in their sectors. Therefore, we intentionally choose those firms with the  smallest market capitalization in each sector so that our shares can be significant enough to apply active ownership as a  complementary tool. Through influencing the corporations to make sustainable and responsible operations decisions,  efficiency and productivity can be enhanced by means of conserving resources, reducing costs, and attracting and  retaining quality employees, or risks can be reduced in terms of negative externalities, which may lead to possibly stranded  assets, potential fines and regulatory intervention, etc. 

The Screening Process & Criteria 

Based on the discussion above, we first performed a preliminary screening of the companies covered by the S&P 500 ESG  Index and built the Portfolio Universe on the following basis: 

• Up to 50 companies will be included in the Portfolio Universe, narrowed down from the original 304 companies  in the index; 

Furthermore, maintaining the same sector weight as the S&P 500 ESG Index (see below)1; 

• Given the need for portfolio analysis and back-testing, only firms with more than five years of trading data (i.e.,  as of December 31, 2017) were considered; 

Is ESG investing profitable?

1 The real estate sector excluded because the real estate companies in the S&P 500 ESG Index are REITs whose investors do not  have voting rights, as we will explain later.

• Considering the size premium brought by relatively small market-cap companies, we ranked companies by market  capitalization in each sector. In the situation of equal-weighted initial investment, we can obtain more shares and  voting rights and influence investee companies on ESG factors by more active engagement.  

Sector Breakdown as of November 30, 2022 (SP Global, 2022) 

Secondly, we used the EQS interface in Bloomberg for the further screening of Portfolio Universe according to the following  criteria: 

Yearly 5-year annualized average total return: Ranked from the highest to lowest. The criterion here aims to  identify stocks that ran over competitors in the last five years; 

P/E ratio: Displayed only. The purpose is to identify cheaper securities in the same sector. • P/B ratio: Greater than 1. Only companies whose market value greater than book value will become selected; • CapEx ratio LF: Greater than 0%. Capital expenditure is an essential driver of company growth. With this condition,  we aim to find companies that have the potential to maintain or expand their businesses. 

We did not introduce additional ESG screening criteria. Because these companies come from the S&P 500 ESG Index. Where the ESG factors have become well considered. Thirty-seven companies remained after this round of screening.  

Thirdly, we downloaded data to Excel and went through each sector in detail to select the best 20 stocks out of 37 at our  own discretion (Attachment 1). For example, for the IT sector, we had to pick six stocks out of 12. We first excluded those  companies with a P/E ratio greater than 40, which is too expensive for the entire IT pool. Then, we chose the stock with  the lower P/E ratio among stocks with the same average five-year annualized return. We used a similar approach when  making our final selections for other sectors. Finally, we selected 20 stocks (Appendix 1), and the sector breakdown is  shown below, which is similar to S&P 500 ESG Indexes and well diversified. 

The Portfolio & Performance Measurement 

We built a Portfolio Final Assignment (“our portfolio”) equally weighted based on the stock selection above. The benchmark  we picked for our portfolio is Bloomberg US large cap (B500) (since S&P 500 Index is not accessible) considering the  following reasons: 

• Our portfolio has the same sector weighting as the B500 index; 

• By comparing with B500, which didn’t include ESG factors, we can also indirectly observe the potential impact of  ESG factors on our portfolio return. 

The comparison between our portfolio’s performance (1, 2, & 5-year returns) and B500 is shown below.   Five-year Return (Our portfolio vs. B500) Two-year Return (Our portfolio vs. B500)

 One-year Return (Our portfolio vs. B500) 

From the screenshots above, we can conclude the following conclusions: 

• For five-year return, our portfolio beat the index by 14.32% (75.81% vs. 61.48%), with allocation effect and  selection effect accounting for 12.57% and 1.75%, respectively. Of the 75.81% total return, the IT and Health Care  

sectors contributed 43.49% (mainly from KEYS and ZEBRA) and 14.54% (mainly from CRL and PKI) separately, well  ahead of the benchmark. Our portfolio didn’t perform well in Industrials and Consumer Discretionary, but it didn’t  influence the return of our portfolio too much considering the lower weight. 

• For two-year return, our portfolio outperformed the index by 4.76% (10.18% vs. 5.42%), with allocation effect and  selection effect accounting for 2.18% and 2.58%, respectively. Of the 10.18% total return, IT contributed 7.04%,  well ahead of the benchmark (-0.68%).  

• For one-year return, our portfolio (-21.11%) underperformed the B500 index (-17.20%). The main reason for the  losses in our portfolio and B500 is the economic downturn: The one-year return (i.e., loss) of the B500 index came  from all sectors, excluding Energy (58.42%) and Utilities (0.15%). Although our portfolio did better in Consumer  Discretionary, Energy, Utilities, and IT compared with the benchmark and avoided the loss in the Real Estate, it  didn’t beat B500 due to the higher weights of asset allocation in Financials and Health Care, which brought  additional loss. 

Is ESG investing profitable?

Total Risk and Active Risk 

  

Total Risk Active Risk 

The total risk of our portfolio is 22.65, a little higher compared with the benchmark (B500: 21.71). The factor risk (22.14)  contributed to 95.54% of the total risk. The main factor-risk exposures of the total risk are US size, USD, and US market.  Compared with B500, the active risk of our portfolio is 6.90 (44.91 % are factor-risk contributions). And main factor risk  exposures are US size, US volatility, and the US trade act. This is consistent with our strategy of stock selection. We picked  relatively small-cap companies from the S&P 500 ESG Index, so the US size exposure exists. Secondly, as all the companies  in the portfolio are listed in the United States, they are affected by USD, US volatility, and US market exposure.  

To sum up, this theme exposes the factor risks, including country, industry, and style. The country risk (i.e., The US  Market) is the most significant risk for the whole theme. As for the active selection of stocks, the style risk (i.e., size) is the  risk that should be further assessed. 

Potential Risks in the Future 

With active engagement being complementary but critical to our investment strategy, there are risks of lower efficacy of  our engagement due to our scale of ownership or the quality of our dialogue and methods used. Risks can also arise from  corporations’ failure to implement their strategies, and our engagement may not be able to achieve the intended goals. 

On the other hand, transformation to more sustainable and responsible operations will likely incur large amounts of capital  investments and worsened financial performance in the short term, which may lead to pressure from asset owners and  beneficiaries. We will become devoted to better communication with our clients to make them understand our efforts and  long-termism.

Appendix 1 Stock List – Portfolio Final Assignment

References Is ESG investing profitable?

UN PRI. (n.d.). New and former signatories. Retrieved December 8, 2022 from https://www.unpri.org/annual-report 2022/signatories 

CFA Institute. (n.d.). Enhancing Investors’ Trust. https://trust.cfainstitute.org/wp-content/uploads/2022/04/Enhancing Investors-Trust-Report_2022_Online.pdf 

SP Global. (2022, November 30). S&P 500 ESG Index. https://www.spglobal.com/spdji/en/indices/esg/sp-500-esg index/?utm_source=pdf_education#overview UN PRI. (2022, September 8). New and former signatories. https://www.unpri.org/annual-report-2022/signatories Clarisse, S., & Thomas, B. (2021). Introduction to ESG Investing. In ESG Investing Official Training Manual (3rd ed., pp. 5).  CFA Society of the UK.

Is ESG investing profitable?

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