Using ESG as a Risk Management Tool

Using ESG as a Risk Management Tool

In the first half of 2020, a period dominated by the spread of the Covid-19 virus and by the shut-down of economic activity in country after country around the world, investing with an eye to environmental, social, and governance issues proved valuable as a risk management measure, according to an analysis from Northern Trust Asset Management.

The authors matched the global developed equity index, MSCI World, against the MSCI ESG World Leaders Index. The World Leaders index, launched by MSCI in late 2007, has largely performed in line with the world benchmark through its life cycle. In the first half of this year, though, it stood out. It outperformed its non-ESG benchmark by 1.1% in the first half of the year. Of this outperformance, 84% was driven by security selection.

Emerging Markets

Looking instead at emerging markets equities, the outperformance has been greater. The MSCI ESG Emerging Markets Leaders Index beat MSCI World by 2.5% through the first half of 2020. This was half-driven by security selection. The outperformance was especially marked in February, 0.70%; April, 0.72%; and June, 1.11%. The outperformance in March was somewhat more modest. And ESG Emerging Markets underperformed the benchmark in January and May, through only by smallish margins, 0.02% and 0.17%, respectively.

Why? NTAM suggests that companies that have failed to protect their workers, especially by failing to provide a clean and safe work environment, protective equipment, or proper sick leave, have paid a cost for it. Those chickens have come home to roost as a consequence of the pandemic. Thus, ESG has worked as a risk management tool both in the financial and in the vernacular sense of the phrase.

Morningstar also looked at much the same issue. It compared ESG funds to non-ESG funds, focusing on the first quarter. It found that 70% of sustainable equity funds were ranked in the top halves of their categories and 44% were ranked in the best-performing quartile. By definition, the norm of representation in a quartile is 25%. Among US stock index funds, 10 out of 12 of the sustainable funds in Morningstar’s large-blend category lost less than did the benchmark iShares Core S&P ETF for that first quarter.

Fixed Income and Credit Quality

NTAM’s analysis began with equity indexes. Then it turned to the fixed-income asset class and the results were similar. The issues that “exhibit robust ESG profiles” do considerably better than those that do not. The ESG leaders also traded at tighter spreads during the worst of the Covid-crisis, an important factor for a risk-control asset.

ESG laggards had more credit downgrades in the first quarter than the leaders, indicated (as a separate NTAM report last spring put it) that “non-financial metrics may have aided the maintenance of credit quality.”

Why does a sustainability focus help maintain credit quality? Issues within that broad domain—labor disputes, food safety concerns, data protection and privacy for technology, play an increasing role in investors’ decisions. Consider the first of those somewhat further. Labor disputes within the global aviation industry have been especially hard on investors of late, in part because that industry is so dependent on the specialized skills of a very small workplace, so that a strike can effectively close an operation down. Fourteen months ago, before most of us had heard of “Covid-19,” British Airways pilots went on strike. Three months passed before the strike was settled, just in time to avoid the disaster of losing the Christmas travel trade.

British Airways has been part of the International Consolidated Airlines Group SA since 2011. The IAG stock price started a sharp upward move on rumors of the settlement, at US$383 on Nov. 30. It plateaued at US$430. Obviously, such matters as good employee relations, (which can be found under both the “S” and the “G” of ESG) are matters that the market regards as valuable. Further, IAG’s credit quality held up in the face of the 2019 challenges, though it hasn’t been so fortunate in 2020, for reasons that have little to do with the labor issues.

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