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The challenge that dwarfs coronavirus

Investors have come through worse than Covid-19 and face greater tests once it blows over, according to this year's Credit Suisse Global Investment Returns Yearbook 2020
March 5, 2020

Share prices are like a cat on a hot tin roof, but before the startling spread of coronavirus caused this volatility, investment managers’ attention was on asset gathering, with environmental, social and governance (ESG) credentials to the fore in promotions.

Market gyrations on the Covid-19 newsflow illustrate how rapidly humans react to unexpected crises, but we’re somewhat slower to panic when trends are long-term and incremental. Arguably, global warming is the greatest threat to our species, but it is only comparatively recently that the role capital markets play has been recognised.

Reflecting its popularity, ESG is the special topic in the Credit Suisse Global Investment Returns Yearbook 2020, a treasure trove of data on long-run asset returns. Compiled by academics Elroy Dimson (University of Cambridge), Paul Marsh and Mike Staunton (London Business School), the yearbook also provides a much-needed sense of perspective on the current panic.

It’s hard to think which decade to use as a yardstick for the coronavirus woes, although thoughts inevitably turn to the Spanish Flu pandemic (January 1918 to December 1920). In the decade following 1910, which also suffered the First World War and the Russian Revolution, the annualised real rate of return on global shares (including dividends) was minus 4.9 per cent.

On the one hand, a virus that has killed a few thousand people (although that is very sad) isn’t equivalent to one of the deadliest pandemics in history that killed 40m-50m. On the other hand, from an investor’s perspective, economies and supply chains were less globally intertwined back then, so it may in any case be best to look at other tumultuous decades. Choosing the 2000s as a comparator, equities made minus 1.3 per cent in real terms in a period that included bear markets following the dotcom crash and the global financial crisis.

Cautious optimism is the core takeaway from the three academics’ work over the years and, even in an era as unsettled as the first half of the 20th century, a tracker in global equities would have more than trebled in value. The next 50 years were something of a windfall for shares, which saw the equity premium (the excess return over US Treasury bonds) average 5.4 per cent a year. The great bull market in bonds has seen this premium moderate since 2000 and the 1950-2020 equity premium is 3.4 per cent. From 1900, the figure is 3.1 per cent, which compounded over 120 years represents significant outperformance.

Bonds aren’t risk-free – even high-quality government bonds that have no history of default are sensitive to interest rates, so the yearbook authors prefer to state the equity premium against shorter-dated US Treasury Bills (T-Bills). The long-run (1900-2019) real equity premium against T-Bills is 4.3 per cent, but going forward the academics estimate the figure will be nearer 3.5 per cent.

 

ESG – investing to tackle our greatest existential crisis

Coronavirus has garnered a reaction from investors akin to Greta Thunberg working herself up on a podium. The Swedish teenager has been cruelly maligned in some quarters, but her hysteria is better placed than those talking about holing themselves up with tinned food until Covid-19 has blown over. After all, the World Health Organization (WHO) estimates that climate change will cause an additional 250,000 deaths a year between 2030 and 2050.

The threat to life and our habitat is the deadly serious aspect to ESG, but investors, rightly, expect outcomes that are beneficial to their wealth as well as society and the environment. By the end of 2019, around $40 trillion of assets were being managed with some degree of ESG oversight. The yearbook study used data from the Global Sustainable Investment Alliance to show how strategies are being implemented. This source hadn’t yet been updated to cover 2019, so missed a year when ESG really blew up in popularity.

The process of ESG integration – which is about influencing how businesses are run through shareholder voting rights – was slightly less widespread than excluding companies from portfolios up to the end of 2018. In the US, ESG integration surpassed exclusion as the prevalent strategy and, given the marketing focus of the past year, it wouldn’t be surprising to see recent data show this trend replicated elsewhere.

Engagement is less puritanical than exclusion and one of the benefits is that while the threat of divestment can alter firms’ behaviour in the long term, attitudes are pragmatic towards cash-generative businesses. That’s just as well, because so-called 'sin stocks' have delivered stellar returns over the past 120 years – the yearbook study has alcohol and tobacco amongst the top-performing industries in the US and the UK.

Classical divestment theory posits that depressing share prices raises companies’ cost of capital and therefore encourages them to abandon 'sinful' projects. Yet, to borrow Professor Marsh’s phrase from the Yearbook presentation, “one person’s cost of capital, is another’s rate of return” and many investors have bet successfully on gambling, weapons, tobacco and alcohol. Risks of regulation and litigation may be high, but the defensive characteristics of these industries in recessions and high barriers to new competitors underpin dependable cash flows.

Good news for investors who think this is just filthy lucre is that companies from less controversial sectors with the same fundamental characteristics can replicate the returns. In a 2017 study, Blitz and Fabozzi, showed that screening for businesses that were similarly profitable and with low replacement capital expenditure requirements, could help portfolios do well without sinful exposure.

Historically, sin stocks are a small part of global market capitalisation, but ESG strategies seek to influence huge sectors such as energy, mining and finance. Divesting sectors from the US market – even big ones – only made a small impact on portfolio returns taking the long view between 1926 and 2019. This is helpful, as it reminds us that markets constantly evolve – although perhaps the impact on contemporary investors of tilting from huge sectors of the day is obscured by the broad time frame of the research.

 

 

In any case, with ESG integration, the modus operandi is the threat of divestment and tilts from index weightings, not outright exclusion. Confusion still exists thanks to an overall lack of uniformity in ESG assessment by index creators. Perhaps it’s because companies have tried to use their proprietary scoring systems as a marketing differentiator, but the yearbook study has found little correlation between the main ESG ratings providers (whose methodology is often overlaid by asset managers) in terms of who they deem white knights on different environmental, social and governance factors.

Single uniform factors for 'E', 'S' or 'G' don’t exist and even the weightings of each heading are different in overall ESG scores between providers. The study stresses that this doesn’t mean that raters are incompetent, rather investors need to use them as a guide to further analysis. After all, if a single 'correct' measure existed, it would already be priced in and there would be little point tilting from market weightings.

Going by research (Babchuk, Cohen and Wang, 2013) into companies with good governance, the market learned after earlier studies that well-behaving companies made higher profits and this knowledge became impounded in stock prices. This suggests that, as the market cottons on, excess returns for virtuous investing can disappear.

Does this mean ESG funds can be closet conventional funds? Citing El Ghoul and Karoui (2017, 2019), the yearbook says over time there is neutral performance versus conventional funds and that, once launched, ESG benchmark indices’ vaunted outperformance disappears as any premium is devoured by the market.

 

Get active to influence

Deep engagement with companies, however, is worthwhile both altruistically and in maximising operational performance. Professor Dimson’s work has shown in the 18 months following investors’ successful engagements with US companies, between 1999 and 2009, cumulative abnormal returns were almost 8 per cent (Dimson, Karakas and Li, 2015). Encouragingly for the environment, many asset owners are seeking to use their influence for good, with more than 2,400 signatories committing to the Principles for Responsible Investment (PRI) charter.

As with any shareholder activism, ESG can be most effective when larger owners are on board and, although marketing claims that ESG can deliver abnormal returns over time should be questioned, positive engagement can help grow productivity. It’s a reasonable hypothesis therefore to say ESG engagement can help keep the normal rate of return for all equity investors sustainable and attractive.