Volatility is Back; ESG Risk Mitigation is here to Stay
A Quarter of Sharp Ups and Downs
The first quarter of 2018 is in the books, and while the headline may be the S&P 500 Index’s first negative quarter since 2015, the defining narrative was the volatile path along the way.
Figure 1: S&P 500 Index Performance over trailing 1 year ending 3/31/18:
Past performance is no guarantee of future results.
January began along the same trajectory as 2017 ended. The S&P 500 Index continued its straight march up through late-January rising almost 7.5% with a favorable backdrop of economic stimulus from tax cuts and company earnings that largely exceeded expectations.
Equity markets then abruptly sold off significantly over two weeks, with S&P 500 Index touching correction levels of -10% on inflation fears and the potential impact on interest rates.
The S&P 500 Index retraced that correction over the balance of February gaining 10% before selling off again in March. March’s negative returns were largely driven by two developments: data concerns at Facebook triggered a steep drop in Technology shares, and later in the month fears of a trade war between the US and China weighed on the market.
The CBOE Volatility Index (VIX) and a closer look at the daily market return swings help illustrate the extent to which volatility returned to the market. After witnessing only eight days in all of 2017 in which daily market returns were up or down 1%, there were a total of 23 days where the market endured a swing of 1% over the last 10 weeks of the first quarter. The VIX, a commonly referred to measure of perceived investor risk, hit its lowest level in more than 25 years during the fourth quarter of 2017 but spiked from levels under 10 to 35 in early February 2018.
Figure 2: CBOE Volatility Index VIX) – Trailing 1 Year Total Return period ending 3/31/18:
Past performance is no guarantee of future results.
With the return of volatility brings a heightened attentiveness to risk. It also presents opportunities for active managers to identify mispriced risk on an individual company level. At Pax, ESG analysis contributes to our risk management, and to better illustrate that link, we’ve rounded up recently published research that continues to support the notion that ESG integration is associated with risk mitigation.
Recent Studies Reinforce Beneficial Relationship Between ESG and Risk
Whether the market is volatile or not, risk is always something investors want to incorporate in their evaluation of opportunities. Understanding the risks inherent in unsustainable operations is at the heart of sustainable investing. Sustainable investors have long understood that ESG factors are material.
A survey last year by the CFA Institute found that about two-thirds of respondents who consider ESG issues did so in order to help manage investment risks. They’re on to something.
“There’s a lot of support for the idea that understanding sustainability can help investors avoid paying too much for companies with mispriced risks”
MSCI, for example, reports that companies with better performance on ESG measures are less likely to have a value-damaging controversy, and are less exposed to systemic risk factors. That, in turn, lowers their cost of capital.
Avoiding controversies is not always possible. Even investors who engage in thorough ESG diligence can sometimes be surprised by an unforeseen and unfortunate event. We’re reminded of that recently when we look at headlines about companies whose value has plummeted due to sexual harassment, and how boards need to include harassment on their list of risks to be overseen.
Controversies like this, according to Sustainalytics, depresses company market capitalization by an average of 6% within ten days of the incident becoming public knowledge — and while those dips in value go away eventually if nothing else happens, they do add up over time. Companies with fewer ESG incidents outperformed the global equity market by 11% between 2014 and 2017, according to the Sustainalytics paper.
One of the ESG risks that the market is quickly learning to understand is climate change. Climate risk is sometimes viewed as primarily regulatory risk — but there are other climate risks as well, including litigation, reputation, and physical risks from things like droughts, floods, fires, and increasingly severe storms. All of these things together add up to a smorgasbord of risks that prompted the Institute and Faculty of Actuaries (IFoA) in the UK to caution its members that they could be subject to litigation from trustees if they do not highlight financial risks of climate change.
One approach to climate risk in portfolio management is to measure and reduce a portfolio’s carbon intensity, something Pax has been doing for several years — and that has real financial impact. A 2016 study looked at 11 different low-carbon, climate-friendly indexes and found that ten of them had higher returns over time than their mainstream benchmarks.
Another of the ESG risks that’s been making a lot of headlines lately is gender discrimination. We believe gender lens investing — which means investing in companies that invest in women — can be an effective strategy for avoiding risk associated with the lack of gender diversity in companies’ leadership ranks. A recent study of Australian firms showed that firms with more women on boards significantly reduced the risk of default.
Balancing Macro Risks with Economic and Earnings Strength
Looking through all the volatility in February and March, the S&P 500 Index is off nearly -10% from its late-January peak. The price decline combined with continuing strong earnings growth have left market valuations at more reasonable levels. However, the return of volatility may be one indication that investors will be more apt to balance risks as they evaluate first quarter earnings. Macro risks that may be factored into investment decisions include the impact of any trade war, signs of inflation acceleration or early signs of a slow-down in the economy.
As always, company-specific ESG risks will remain a focus at Pax. We believe integrating ESG into investment decisions can have a real, positive payoff for investors that undergo the effort. And while every idea does not outperform financial markets every day, we believe that in the long term, sustainability will be a more rewarding risk-return proposition than the alternative.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk.
One cannot invest directly in an index.