TwentyFour Asset Management
As regular readers of this blog will know, TwentyFour has adopted ESG integration throughout its investment process for all strategies, and launched its first sustainable fund offering in January 2020. In doing so, we have engaged in some fascinating debates with clients and peers about the growing impact of ESG objectives on the fund management industry, and on fixed income markets in particular. Here are a few of our predictions for the years ahead.
1) ESG outperformance will reach a tipping point
Our performance attribution analysis has confirmed to us that more ESG friendly sectors and securities tend to outperform those that are less so, and our back-testing research shows this has been the case for some time. It is important to recognise that at some point this ESG outperformance trend will not always be a one-way bet. On pure relative value grounds there will come a point where ‘sin’ sectors and stocks will look so cheap that the value will become compelling for investors. Sustainable funds will obviously not be able to capture this value, but integrated and non ESG funds will. So-called ‘sin’ assets also tend to be higher yielding and in defensive sectors – think tobacco and alcohol – and therefore traditionally are seen to offer a degree of protection during downturns.
In the long run, however, we are in no doubt that ESG friendly assets will outperform those that are less so. Indeed, any portfolio manager – whether focused on ESG or not – should be wary of the possibility of a company becoming shunned by the market for ESG reasons as this could materially impact performance.
2) ‘Sin stocks’ may leave public markets
One of the livelier debates in ESG investing is exclusion vs. engagement, and which approach can be more effective in changing firms’ behaviour. We believe in engagement in the right circumstances, and one of our favourite examples of taking into account ESG ‘momentum’ is the UK energy supplier SSE, which showed us a demonstrable plan in 2013 to take coal from 59% of its input in 2013 to 5% within five years. Exclusion in sustainable funds also has its place; what can you change about gambling or nicotine addiction? We have never been fans of vaping as an alternative, for example.
There are two issues that must be reconciled here: the understandable moral desire of an investor not to fund ‘sin’ industries, and their absolute desire to achieve better societal outcomes. For the latter objective the missing ingredient is government legislation. If capital markets refuse to fund a business that is perfectly legal, then its cost of capital will likely rise to a point where it becomes attractive for a private entity to acquire it on the cheap. This could be a private equity firm, an overseas investor, or anyone. The point is the product will continue to be supplied, only the beneficiary will have changed.
3) ESG data sources will improve
ESG data providers generally focus on publicly listed equities, specifically the data included in their annual report and accounts along with the possible addition of information included in a Corporate and Social Responsibility report. The problem for fixed income investors is that not all bond issuers are listed companies. We estimate that unlisted issuers can account for somewhere between 30% and 40% of our holdings, which is a significant gap in ESG data coverage. Moreover, a recent study* has found that the correlation of ESG ratings between the main five providers is 61%, compared to almost 99% for the major credit rating agencies. More than ever, doing our own work and thinking about the issues is clearly critical. The collection and analysis of ESG data is still relatively new and we fully expect this to be an area which will improve over time, both in terms of quality and quantity, as standards and definitions gain traction.
4) ESG passive funds will come in for (deserved) criticism
We believe the execution of ESG and sustainability principles demands an active management approach. Effective engagement is not just a matter of periodic voting policy, matters can arise in real-time which require timely and active engagement. In our view, as the market increasingly recognises the limitations of rigid rules, the inability of a typical passive fund to account for important factors like momentum, or effectively engage with firms on specific real-time issues, will become a differentiating factor for asset managers and asset owners.
5) Green bonds will flourish, but not without controversy
The green bond market, like so many other areas of ESG, is relatively new and growing quickly. Some $271bn worth of these instruments were issued in 2019, representing an annual growth rate of 49%**, and the market is on track to hit $1tr outstanding shortly. Issues with use of proceeds and outcomes reporting are well documented, and the European Union is working on an accepted framework. One particular area of concern for us is that despite the growth in supply, demand for green bonds has remained far greater, creating the perfect storm for some potential abuse at the fringes and associated risks for investors.
6) Some impact funds will not perform as investors expect
Our specific worry on impact funds is that at a time of excess demand, some impact investments will be funded in debt markets when really they represent equity risk. While we accept this market is set to grow in exciting ways, this is one of the classic early market growing pains we would like to avoid.
7) ESG will soar in the US
The general consensus is that the ESG investing movement in the US is lagging behind Europe and elsewhere. Last summer, for example, the US Congress rejected a move to introduce European-style ESG reporting standards. However, while there is little push at the government level there is a real drive for change from the ground up. Currently ESG investing is concentrated mainly in coastal states such as California, and from these centres it is spreading. Interestingly we can see this originating as much at a corporate level as anything else; witness the stance JP Morgan has taken on US prison funding, for instance. Pressure on, and from, asset owners is also increasing and we expect once that tipping point is reached the US uptake of ESG will be extremely rapid.
* ‘Aggregate Confusion: The Divergence of ESG Ratings’, MIT Sloan School Working Paper 5822-19
** ‘Green Bonds – Increasingly Relevant in the Corporate Bond Market’, Deutsche Bank Research.