ESG investing: how to understand, measure and mitigate

Volatility in sustainable strategies may leave investors hesitant about ESG. But in the long run, a sustainable approach is likely to outperform, argues Pendal’s MICHAEL BLAYNEY

• ESG risk underappreciated
• Careful management and mitigation required
• Find out about Pendal Sustainable Balanced Fund
• Browse Pendal’s range of multi-asset funds

VOLATILITY in some sustainable strategies may leave investors hesitant about ESG.

But research from Pendal’s multi-asset team suggests the investment risks of ESG can largely be quantified and mitigated.

Investors should not get too caught up in short-term volatility of sustainable funds as they remain likely to outperform over the longer term, argues Michael Blayney, who leads Pendal’s multi-asset strategies, including Pendal Sustainable Balanced Fund.

New research from Pendal’s multi-asset team highlights the importance of carefully managing the different kinds of risk introduced by an ESG approach to investing — and understanding the biases introduced to a portfolio by sustainable screening.

The research shows a sustainably screened approach delivered outperformance over nearly two decades up to the disruptions of the Covid pandemic, despite multiple periods of short-term underperformance.

“Investing sustainably is the right choice in the long term, but investors need to understand how much and for how long their performance could differ from unscreened portfolios — and be comfortable with that,” says Blayney.

“The truth is that all active management goes through cycles of performance, and often people have a knee-jerk reaction to underperformance.

“But we think that ESG funds will give you the same or better performance over the long term because they have a whole range of structural tailwinds to do with regulation, consumer preferences and the energy transition.”

Blayney says 2022 has made some investors more cautious on ESG oriented funds, with European data showing slowing inflows into impact funds and outflows for sustainable funds.

The shift in thinking among some investors partly stemmed from a poor appreciation of the risks introduced by a sustainable investing approach as well as how those risks can be mitigated, he says.

Managing unintended risks

ESG screening typically introduces sector, size and style bias relative to an unscreened index.

In more concentrated indices it can also produce stock-specific risk if a large stock is screened out — for example miner BHP in Australia or luxury goods maker LVMH in Europe.

“A typical ESG screen could very easily screen out 20 per cent of the Aussie share universe and 10 per cent of the global share universe — whcih is material,” he says.

Sector risk has been a feature of ESG’s post-Covid underperformance, as energy prices soared on disruptions from the Ukraine war.

“Most sustainable funds are underweight energy or in some cases have zero energy exposure because of the fossil fuel exposure,” says Blayney.

This risk can be mitigated by actively including commodity futures in a portfolio or investing in renewables with exposure to spot energy prices, Blayney says.

Active management

Managing actively at an asset class level in a more sophisticated way than the approach taken by an “ESG Index” can also help.

“A good fundamental equity manager will be thinking about those things.

“If I just screened out BHP, are there other companies or maybe a combination of companies that give me similar exposure to the commodities I just screened out?”

Size risk occurs because many companies making a positive impact are small and medium-sized businesses.

This year, markets have turned away from smaller companies and chased the US mega cap tech stocks.

The tech megacaps are generally not hard exclusions from ESG portfolios, but because of their size and volatility they can have a big impact on portfolio returns if they are underweighted — for example due to a “positive impact” orientation in a portfolio, or even simply active portfolio construction.

There is no obvious hedge for this, says Blayney, but investors should be mindful of the risk and size positions sensibly as a result.

Style risk can also be an issue because many “more sustainable” companies tend to be growth focused, which means they are more sensitive to interest rate changes.

Blayney says this can be mitigated by actively managing bond exposures to compensate.

Tracking error explained

Pendal’s research quantifies the level of risk inherent to ESG portfolios by measuring the tracking error of ESG indexes compared to unscreened indexes over an eight-year period.

Tracking error is a measure of how closely a managed fund tracks its benchmark index.

A low tracking error typically means a fund is very close to its benchmark, while a high tracking error can mean the fund is more volatile and may deviate from its benchmark more often.

Pendal’s research found that for screened Australian equities, the tracking error based on the indices used was just over 2.5 per cent, while for international developed market equities, the tracking error was around 2 per cent.

“To put that in context, a core unscreened Australian equities strategy typically runs a tracking error of 2 per cent to 3 per cent while global equity managers might run tracking errors of between 3 to 6 per cent per annum.

“So, with ESG, you’re getting something like at least half of the risk that you would get from an active manager, simply from negative screening.”

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About Michael Blayney and Pendal’s Multi-Asset capabilities

Michael Blayney leads Pendal’s multi-asset team. Michael has more than 20 years of investment management and consulting experience. He was previously Head of Investment Strategy at First State Super and head of Diversified Strategies at Perpetual.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

The team — which also includes Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal account manager here