Impactful Asset Allocation
A Look into ESG, Impact Investing, and Strategic Allocation
Preface
While this piece largely includes my own particular views on ESG, Impact Investing, and Strategic Allocation; the general idea and theme of this paper is derived from ARK Invest Management.
Impact, Who?
Developing a proper nomenclature surrounding ESG (Environmental, Social, and Governance) and Impact Investing has become a rising concern for legislative bodies, asset managers, and individual investors. There is no ‘one size fits all’ answer to this either. Impact means something different to the investor that allocates capital in Tesla to limit drunk driving and the investor that allocates capital in Tesla to support clean energy and electric vehicles. There is no arbiter in this discussion; but, for purposes of this paper, I’ll define ‘Impact’ within the lens which I think best suits this purpose. Impact Investing involves investments in organizations that generate future tangible, or intangible, beneficial social, or environmental, impacts alongside healthy risk-adjusted financial returns. The truth behind this statement means that there is no divorce between an invested dollar and impact in general, but impact investing is through the lens of social, or environmental, goals. Thus, the question stands, how do we differentiate between which securities are ESG and which are not. For the purposes of this paper, we can take a page out of Warren Buffet’s book and exclude organizations that produce tobacco or have tobacco sales, additionally excluding organizations involved in controversial weapons (i.e., nuclear), and rely heavily on the big names within the ESG space such as the United Nations Global Compact and MSCI’s scores on public organizations.
Impact, Impacting Capital Allocation
Figure 1: Sustainable Investing in the United States (1995-2020)
Source: The Forum for Sustainable and Responsible Investment (USSIF)
In my view, it’s an indisputable fact that the investing themes surrounding ESG and Impact Investing are here to stay. With a growing relevance in the genre of climate awareness, change, and advocacy; front run by an increasingly progressive America, there has come a snowballing, and developing, forward-looking reliance on organizations to ‘do their fair share’ and ever so, investments in organizations that do. In fact, before 2013, only 20% of S&P 500 companies choose to disclose their ESG responsibilities; today, that number is close to 85%.
Figure 2: Average Company Lifespan of S&P 500 Index
(Years, Rolling 7-year average)
Source: Innosight, 2018; “2018 Corporate Longevity Forecast: Creative Destruction is Accelerating”
Ark-Invest.com
Forecasts are inherently limited and cannot be relied upon.
Ark Invest’s whitepaper on ‘Innovation Allocation’ describes the fascinating turnover within the S&P 500. Although I agree that this could be due to Innovation and forward-looking allocation towards innovative organizations, I believe that there is no divorce between being innovative and promoting ESG values. If we carry forward the notion that innovative organizations are responsible for the high turnover within the S&P, then the S&P 500 ESG Index is good proof of this, throughout the S&P 500 Index there are only 154 constituents that were ultimately excluded from the S&P 500 ESG Index, or 23.43% via market capitalization. It is my view that this cyclicity will continue to favor organizations that both disclose their ESG factors and remain forward-looking; but to nail the point home, there is no divorce within these concepts.
Allocation Towards Impact: Comparison to Emerging Markets
Ark Invest’s original whitepaper thoroughly discusses their views on the trend of Emerging Markets; it’s seminal, thorough, and I highly recommend reading it. I will attempt to weave their comparison with emerging markets as it fits the scope of this paper.
I believe that ESG and Impact Investing has already developed into a sub-asset class and will continue to flourish under that scope for a long time to come. When the International Finance Corporation (IFC) began to track total return data for ten developing markets in the 1980’s they discovered “attractive results… making a good case for increased investment.” As the case for developing markets strengthened, with extremely healthy upside returns in comparison to the World Indexes, investors initiated a trend within developing markets that has carried through to today.
I believe that similarly, so will ESG and Impact Investing. I have identified five major themes and ten key utilities across the scope of ESG and Impact Investing that provide Impact within their respective fields on a large and developing basis, I believe these provide substantial potential and idiosyncratic diversification benefits. While it is certainly true that there are higher operating costs associated with organizations that ‘do things the right way,’ they all provide significant variant advantages that create healthy risk for portfolios looking to create Impact.
Based on Figures 3 and 4, there are substantial correlative differences between ESG and Impact Investing with that among the various S&P sectors. Figure 3 was compiled by ETFs selected by me that are intended to represent each of the 11 sectors within the S&P 500. Figure 4 was compiled given the five major themes and ten key utilities previously referenced. One or more individual stocks were chosen to represent the key utilities. The average correlation between S&P sectors is 0.63, whereas the average correlation between the ten key utilities is more than half, at 0.23. On an aggregate basis, a diversified collection of key utilities allows a good case to create value within portfolios, on a risk-adjusted basis.
Figure 3: Five-Year Weekly Correlation of the S&P Sectors by SPDR ETFs
Data Source: Yahoo Finance, Five-year weekly fund price correlation data as of December 21, 2020
Investing in organizations that are both forwards-looking and ESG minded provides advantageous downside protection as well. In periods of substantial economic downturn investors often limit exposure in high-beta equities and look towards stable cash-giants. While ESG minded organizations typically experience higher organizational costs; specifically, those who benefit from economies of scale and high switching costs should not provide asymmetric downside risk.
Figure 4: Five-Year Weekly Correlation of Ten Utilities Represented
Data Source: Yahoo Finance, Five-year weekly stock price correlation data as of December 21, 2020
As ESG and Impact Investing continues to evolve, domestically and internationally, it is my view that investors will continue to allocate capital and devote time towards the flourishing sub-asset class that is ESG and Impact Investing. In the aggregate, ESG has the potential to work with organizations of all shapes and sizes, but currently, it makes the most sense for the largest organizations to invest time and energy in ESG capabilities. In this view, I believe that ESG and Impact Investing, on a passive scale, provides substantial stability and ‘index-hugging.’ To label this correlation I’ve created and analyzed three hypothetical global equity portfolios to identify the potential of risk-adjusted returns in the long run, Figure 5.
Figure 5: Hypothetical Global Equity Portfolios With and Without ESG
Data Source: Yahoo Finance, Five-year daily prices as of December 21, 2020
The global portfolio excludes any impact of pure ESG motives and weights US, International Developed, and Emerging Markets as 60%, 30%, 10%, respectively. The following portfolios include ESG allocation at 10% and 15%. The ESG portfolios generated 0.45% and 0.63% alpha’s, respectively. This is remarkable given the asymmetric increase in standard deviation.
On an active basis, I believe there is certainly a possibility to out-perform common benchmarks by employing ESG and Impact Investing to identify organizations that are forward-looking and ESG minded. As a more progressive America begins to take shape, investors should be wary of how the organizations they invest in fit the mold of expected policy changes. Because environmental and social expectations will only increase, investors would be apt to think organizations that are quick to develop and adapt will deliver the most to their customers and their shareholders.
Conclusion
I believe that as the global equity market’s underlying organizations start to invest within their organizations, through policy or by choice, towards ESG considerations, they will create growth trends within capital markets. Taking notes from institutional trends, individual investors should consider not only the impact they create from their investments, but thematic trends that contribute to the upside potential of their portfolios. It is my belief that active ESG and Impact Investing expands the potential for investors to outpace traditional indices on a risk-adjusted basis.
As ESG trends continue to develop and eventually flourish, investors should consider allocations towards such, on an equity basis. Market incumbents only stay that way because they are forward-looking and anticipating a different future, one that I believe is green.
Disclosures
Ownership and material conflicts of interest
The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company or any company aforementioned. The author of this report intends to initiate a position within 90 days upon publication in the following equities; SQ, ANTM, RMD.
The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report.
Receipt of compensation
Compensation of the author(s) of this report is not based on investment banking revenue.
Position as an officer or a director
The author(s), or a member of their household, does not serve as an officer, director, or advisory board member of the subject company.
Market making
The author(s) does not act as a market maker in the subject company’s securities.
Disclaimer
The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security.
This paper is intended for informational and educational purposes only and should not be considered investment advice or any recommendation to buy, sell, or hold any particular financial interest in a security. The representative securities particularly identified in Figures 3, 4, and 5 were selected based on my methodology. The reader should not assume that an investment identified was or will be profitable. Data is unreconciled and from a third party system.
Works Cited
Nielsen. Sustainable Shoppers Buy the Change They Wish to See in the World (https://www.nielsen.com/eu/en/news-center/2018/investing-sustainability-research/)
ArkInvest. Rethinking Innovation Allocation (https://ark-invest.com/white-papers/rethink-asset-allocation/)
SpGobal. S&P 500 ESG Index, Integrating ESG Values into the Core (https://www.spglobal.com/_media/documents/the-sp-500-esg-index-integrating-esg-values-into-the-core.pdf)
Ark Invest; International Finance Corporation. IFC: The First Six Decades” (https://www.ifc.org/wps/wcm/connect/corp_ext_content/ifc_external_corporate_site/about+ifc_new/ifc+history/establishing-emerging-markets_
Yahoo Finance. Historical Data. Correlation matrix includes the following ETFs to represent their respective S&P Sector: Communication Services Select Sector SPDR ETF (XLC), Consumer Discretionary Select Sector SPDR ETF (XLY), Consumer Staples Select Sector SPDR ETF (XLP), Energy Select Sector SPDR ETF (XLE), Financial Select Sector SPDR ETF (XLF), Health Care Select Sector SPDR ETF (XLV), Industrial Select Sector SPDR ETF (XLI), Materials Select Sector SPDR ETF (XLB), Real Estate Select Sector SPDR ETF (XLRE), Technology Select Sector SPDR ETF (XLK), Utilities Select Sector SPDR ETF (XLU). Note, I calculated the following correlation coefficients between each fund’s non-adjusted closing price as provided, using correlations across five years, if not, fund’s life. The correlation coefficient ranges between -1.0 and 1.0. With the time frame selected the initial start date was 12/21/2015 (for applicable funds).
Yahoo Finance. Historical Data. Correlation matrix includes the following stocks to represent their respective key utility: Electric Vehicles = Tesla (TSLA), Renewable Energy = NextEra Energy (ERP) & First Solar (FRP), Plant Based Food = Beyond Meat (BYND), Organic Grocery = Hain Celestial (HAIN) & Sprouts Farmers Market (SFM), Unbanked Representation = Square (SQ), Safe Drinking = Evoqua Water (AQUA), Water Infrastructure = Mueller Water (MWA), Telehealth = Teladoc Health (TDOC), Digital/Cloud Health = Resmed (RMD), Health Benefits = Anthem (ANTM). Note, I calculated the following correlation coefficients between each stock’s non-adjusted closing price as provided, using correlations across five years, if not, fund’s life. The correlation coefficient ranges between -1.0 and 1.0. With the time frame selected the initial start date was 12/21/2015 (for applicable stocks).
Yahoo Finance. Historical Data. Market Representations include the following: US: iShares Core S&P Total US Stock Market ETF (ITOT); International Developed: iShares MSCI EAFE ETF (EFA); Emerging Markets: iShares MSCI Emerging Markets ETF (EEM); ESG: iShares MSCI KLD 400 Social ETF (DSI). Note, representative portfolios should not guarantee future results, data is unreconciled and from a third party system and should be provided for illustrative and hypothetical situations only. I chose DSI due to its applicable scope and length of track record. This is not a recommendation to buy, sell or hold any particular security represented. The risk/return statistics and ratios were calculated from Yahoo Finance’s historical data and was processed through Microsoft Excel.
U.S. Securities and Exchange Commission. ESG Subcommittee Asset Management Advisory Committee https://www.sec.gov/files/update-from-esg-subcommittee-09162020.pdf
Written by Luke Anderson, Undergraduate Economics Student