Avoiding unintended biases is key
by Emily LawrenceMs. Lawrence is North American Director of Sustainable Investing Client Engagement at Northern Trust Asset Management. Visit www.northerntrust.com.
A rising tide lifts all boats. When markets are up, it can be harder to determine whether investment portfolio performance is a product of true skill, or happenstance. True skill and thoughtful portfolio construction are more clearly identifiable during times of market volatility. Sustainable portfolios, those that integrate ESG analytics into the portfolio construction process, can be built to navigate long and midterm market trends, while also bolstering against near term market activity. At Northern Trust Asset Management, our investment philosophy is to be compensated for the risks that we take. We believe that thoughtful portfolio construction can allow investors to invest in companies that are better positioned to manage macro-economic trends like a changing global climate, while avoiding unintended and uncompensated portfolio risks and biases.
US investors have demonstrated interest in sustainable strategies over recent years. The beginning of this trend aligned generally with a time of consistent market growth and limited volatility. In spite of greater volatility stemming from the start of the pandemic period, Morningstar data shows steady flows into sustainable funds, peaking at $67.4bn in flows into US vehicles during 2021. This trend began to pull back in 2022, as ESG funds experienced similar contraction to that of the broad market which slowed the momentum of flows to all strategies, ESG adoption included.
As we look more closely at this pull back, we can get some insights into how sustainable strategies have been capable of chinning the bar on investment performance, and which approaches have been effective. We contend that ESG strategies that are guided by the philosophy that ESG factors can assist in evaluating investments and managing risk are strategies that can meet the mark on generating competitive investment performance. Modern sustainable investing strategies in many cases use an assessment of material investment risks, integrated alongside traditional investment analysis. These are strategies positioned to benefit from investing in issuers that exhibit robust management and proactive oversight of material risks, such employee health and safety violations or large scale incidents of environmental degradation. An example of this is highlighted by the relative outperformance of sustainable funds compared to peers at the onset of the Covid 19 pandemic, when 70% of sustainable equity funds ranked in the top halves or quartiles of their categories and 44% ranked in the best performing quartile. Looking closely at a specific example, this can be illustrated by the MSCI World ESG Leaders Index compared to the MSCI World during this timeframe. This index family was designed to leverage ESG risk ratings to build a portfolio with broadly diversified exposure to higher rated ESG issuers while maintaining relatively low tracking error. In the first half of 2020, the World ESG Leaders index outperformed its market cap-weighted parent by 1.1%, largely driven by stock selection.
Sustainable investing vehicles represent a broad suite of investment capabilities, integrating different datasets and tools, including exclusions, ESG risk analytics and ESG themes like climate risk, into portfolio construction. In other words, sustainable strategies may vary widely in approach and intention; investment performance expectations may vary widely, depending on type of investment approach, the datasets considered, and the way they are considered in investment decision making. These more challenging market conditions allow investors greater transparency into the merits of these different approaches and techniques; investment performance during this timeframe lets us see more clearly which strategies are better positioned to nimbly manage the market volatility. For example, strategies that rely primarily on exclusionary tactics may introduce broad sector bets into the portfolio. Some studies suggest that strategies in this category may miss out on returns.
Recognizing that there is a lot of nuance in what data is integrated, and how is it integrated in sustainable portfolios is a critical step for investors as they conduct their due diligence. There is no one-size-fits-all sustainable strategy, which we can see born out in the variety of capabilities available in the market. Studying and comparing investment performance of these capabilities can give insight into that. One clear way we can focus on managing risk is through avoiding sector biases. Data suggests that ESG funds which exhibited sector biases tend to overweight the tech sector while underweighting the energy sector. Therefore, particularly during times of market volatility, thoughtful portfolio construction design including robust risk controls may be the key differentiator between sustainable strategies.
Let’s continue with the example of index constriction to further evaluate this point. NTAM has a point of view on building portfolios that are leveraging material ESG analytics in a way that avoids unintentional biases. Our approach to portfolio construction is aligned with our philosophy to control for uncompensated risks. Leveraging over 3 decades of experience building portfolio with socially responsible objectives, and managing over $137 billion in sustainable assets globally, NTAM has experience partnering with some of the most sophisticated global investors integrating sustainable investing objectives into portfolios. Take for example the Northern Trust ESG & Climate family of indexes. This index family follows a rules based approach to portfolio construction, leveraging a purposeful sustainable investing methodology with a thoughtful approach to risk control. The end result is a family of indices with robust risk management, mindful of tracking error and sector biases, which exhibits broad market exposure to companies that better manage material ESG risks.
If we focus on the US Large cap version of this index family and compare its active sector weight to the MSCI USA Index, a large and mid-cap US index, and use the MSCI USA Choice ESG Screened index for reference we can see these sector biases at play. The MSCI USA Choice ESG Screened index is a free-float adjusted market capitalization weighted index that is designed to reflect companies that have better ESG ratings relative to their peers, alongside an exclusionary approach to fossil fuels alongside other exclusionary factors. Relative to the MSCI USA index, you can clearly see the Northern Trust ESG & Climate index very similar sector allocations, which differ minimally from the broad market cap weighted index.
For the MSCI USA Choice Screened index, we can see sector weights allocated as an overweight to IT, Financials and Real Estate, and underweights to Communication Services, Energy and others. ESG strategies that leverage unconstrained exclusions or significant sector bets take uncompensated active risk. In 2019, during a market environment that was advantageous for the FAANG stocks and the energy sector lagged, these strategies would be more likely to outperform, but given the relative strength of the energy sector over the course of the last year, strategies that take this sector bet may be positioned to significantly underperform the broad market.
Acknowledging that investment performance has been a challenge during the 2022 cycle, we believe that controlling for uncompensated risks like sector biases will be contribute to better risk adjusted returns over time. Appetite for sustainable strategies persists, and the field of pooled investment capabilities across different asset classes continues to grow, making adoption more accessible than ever. We believe the current market climate will result in investors becoming more discerning in their review of the sustainable strategy landscape, including a deeper look at the method and use of ESG datasets, the discipline of how portfolios integrate ESG analytics into the investment process and the acumen and commitment of the investment team. We are of the firm belief that investors can benefit from seeking ESG strategies and do not need to forego investment performance in doing so. More sophisticated investment due diligence will support investors in selecting strategies that align with their investment objectives and risk budget.