Environmental, social and governance (ESG) investors are becoming increasingly exposed to “uncompensated” market risks, a new study by Northern Trust Asset Management (NTAM) has found.
The NTAM analysis of almost 90 institutional portfolios found ESG factors accounted for only 40 per cent of ‘active risk’ in high-ESG strategies as other biases such as country, sector, style and currency come into play.
Michael Hunstad, NTAM chief investment officer, says in the report that of the 60 per cent of non-ESG influences in high-ESG portfolios in the study only 20 per cent could be linked to “compensated” factors like quality and low-volatility with the remaining 40 per cent of risks offering zero rewards to investors.
“Regardless of your view on the return implications of ESG, the bulk of your active risk could come from uncompensated, non-ESG sources,” Hunstad says. “That’s a huge concern.”
And the “hidden” style risks in high-ESG portfolios have become more pronounced since 2019, the NTAM study found, as investor interest in the sector took off.
“The [rising style bias] phenomenon may be related to the increased appetite for ESG investing sparked by the pandemic,” the report says. “For example, stocks with high ESG ratings had high levels of inflows as many outperformed during that period, which greatly increased their correlation with momentum.”
NTAM also found high-ESG strategies tend to dilute active risk more compared to average portfolios. Adding specialist ‘satellite’ ESG strategies to a multi-manager portfolio barely budged the overall ESG exposure (due to a ‘cancellation effect’), too, the study says.
Meanwhile, active managers typically lowered the overall ESG scores in the portfolios analysed by NTAM.
“This may be explained by the increasing valuations for ESG leaders that have made active managers less willing to own them,” the report says. “Between 2018 and 2021, the price/book differential between ESG leaders and the MSCI World Index nearly doubled.”
Total portfolio ESG content is also “highly sensitive to over-diversification”, NTAM found, with ESG scores inversely correlated to the number of underlying managers.
“High levels of uncompensated risk would be fine if it were eliminated through diversification,” Hunstad says. “However, that is not happening. In fact, we often see the opposite, worst-case scenario: diversification lowers compensated risk and even ESG content, while leaving uncompensated exposures.”
Institutional investors, however, do appear to making some E-progress with all of the portfolios in the NTAM showing a lower carbon exposure compared to the average.
NTAM says most of the below-benchmark carbon weights “were sizeable and likely intentional”.
“These meaningful shifts have been persistent over this multi-year period and may mark a notable long-term shift in investor objectives,” the study says.
The recent analysis focused on portfolio equity holdings but Hunstad says the findings probably apply across all asset classes.
“We’re conducting a similar study in fixed income and the same results seem to apply: over-diversification, dilution of ESG exposures, and a lot of uncompensated risk,” he says.