Why didn’t portfolios rooted in the tenets of socially responsible investing (SRI) do a better job of insulating investors from the blows of the financial crisis?
This is a question that not enough people in the SRI space are honestly confronting, says Christoph Butz, sustainability expert at Pictet, one of Switzerland’s largest private banks, with roughly $100 billion in actively managed assets. Butz co-authored a report recently published by Pictet, called 'How to Survive the Next Crisis: A New Approach to Socially Responsible Investment,' which both addresses the question and suggests a fix.
“Unlike what we would call the ‘ESG materialists,’ who look for financial out-performance in ESG indicators,” the report explains, “we suggest taking exactly the opposite approach: searching for sustainability in fundamental financial indicators.”
Butz believes that while filters that focus on ESG (shorthand for environmental, social and governance) factors are helpful, he says that all the attention around extra-financial data has distracted from the core financial information that can help forecast a company’s future financial health.
To find out which financial indicators best predicted a company’s long-term stability and its resistance to wider market shocks, Butz and his research team collected a large number of financial factors that they suspected may mitigate risks to companies and investors. Back testing allowed the research team to narrow down its list to only those factors that did indeed appear to be associated with long-term company health and strong returns. The paper focuses on two of these financial indicators of sustainability (Butz says the rest are proprietary): low to moderate leveraging, and stable and organic asset growth (as opposed to growth through mergers and acquisitions).
To test the hypothesis that this particular cocktail of financial indicators would indeed add value and offer risk protection, the research team created several portfolios that selected for these indicators and simulated their performance between the period of January 1999 and November 2010. Indeed, the simulated portfolios outperformed, except in the steepest of market rebounds. (Read the full report.) Currently, this “financial stability” layer applies to about half of the $2 billion in SRI assets managed by Pictet.
Institutional Investor reporter Katie Gilbert recently spoke with Christoph Butz about how those investments are performing for Pictet, and where all this leaves traditional SRI and ESG approaches –and why Butz thinks this new research could help push those approaches into the mainstream.
Katie Gilbert: Would it be fair to say that your main point in the paper is that ESG, as it’s currently practiced, doesn’t concern itself enough with financial stability? Because it sounds like you’re not suggesting that ESG focus less on anything it currently concerns itself with.
Christoph Butz: That’s absolutely right. We don’t do ESG or SRI bashing. We think that it’s still necessary to detect ESG risk. But it’s obviously not enough to give a portfolio the desired financial characteristics.
I think that, looking at the development of this SRI market, you cannot just pass over the crisis. If you look at how SRI funds performed in the crisis, you’ll see that they did not do worse, but they did not do better, either. If you’re serious in this domain, if you’d like to improve, then you have to ask yourself, ‘Why not?’
It was always implicitly, if not explicitly, suggested to SRI investors that they would have a portfolio that, in a financial sense, is less risky and more stable. Statistically, this was not the case. This was really the motivation for the research we’ve done and for this paper. You have to move forward now to learn these lessons, and I think we have found something that goes in that direction.
KG: Tell me about the new investment process that resulted from your research.
CB: We have two steps in this improved investment process: the first is actually the traditional ESG screening filter, which is based on about 100 environmental, social and government criteria. This is, let’s say, the standard process. The idea of this first step is to screen out those companies that do not have acceptable standards for an institutional level of good practice in these extra-financial domains. This probably cuts the investment universe in half.
Then the new model kicks in. The new model is actually geared toward overweighting the companies that have these sustainable financial characteristics – lower leverage, moderate asset growth, more concentrated, stable ownership, and so on. The financial sustainability factors are responsible for the final weight of the portfolio.
It’s been three-quarters of a year now since we integrated this into the portfolios of our clients, and it actually delivers exactly as predicted, meaning that if the stock market is going moderately up, you add value. If the stock market goes down, you would add value, if the stock market goes up very heavily, then you would lose out a bit. The pattern has been as predicted.
I think it has the potential to be mainstream, or get SRI finally out of its niche. This might become something of a no-brainer – you say, well you have the SRI-ness of the investment, and on top of that, you have something that adds financial value.
KG: Does this financial sustainability filter always have to be coupled with an SRI filter?
CB: That’s what we suggest because I’m working primarily for SRI clients, and they clearly have preferences in this area. What we believe is that if you have a product that would just be conventional and then add this financial sustainability layer, it would certainly add value in terms of reducing wider economic externalities or stabilizing the system, but of course with a traditional ESG filter, you also promote good practices, good corporate governance, better social practices, and that is something that is very important in my view. For our SRI clients, this is certainly the first choice, but as you say, in principle, you could separate the two approaches. But here, for the time being, it’s really the full package.
KG: Is it possible that the particular financial sustainability factors you’re focusing on as the best bellwethers are actually those that simply apply most closely to this most recent crisis?
CB: This is a legitimate question. It’s true that the portfolio simulation just covered the last decade. However, it’s not a backtracking exercise, where you pick the winners afterwards, but you start in 1999, building a portfolio. The factors we included in the model have done consistently well for 20 years. So you can say, ‘Fine, twenty years, but probably over 30 or 40 years it would be different.’ That’s a possibility. But you’d probably agree that these factors also intuitively make sense; it’s a commonsense fact that they have worked very well and done well over this 20-year timeframe. And when we implemented them and simulated them, and combined them in a portfolio, they still delivered. So we are quite confident that these factors could go on having this protective effect and this value-adding effect, making portfolios less risky and outperforming.
It’s also not like we have our final set of 7 or 8 financial factors and we will stick to them no matter what may come. It’s more that we have picked them because we have seen that they have delivered in the sense they were intended to. But it’s ongoing work, and we are testing and identifying other factors that we believe are interesting from a wider sustainability perspective, and that have delivered positively in the past. We would like to be adaptive, meaning that if a factor loses its value-creating or its risk-reducing characteristics, then we would be willing to discard that factor and replace it with another.