Comments Off on ESG: manufacturers, not energy companies, are the main culprits
By JOACHIM KLEMENT
When it comes to ESG risks, investors are increasingly aware that they may cause significant costs to a company and its shareholders. This is the reason why I am such a fan of ESG momentum strategies, i.e. investing in companies that are making credible and sustained efforts to reduce their ESG risks. With lower ESG risks and better management of these issues come lower costs and higher profitability. After all, every prevented accident will increase your bottom line, even if you can’t measure the costs from an accident avoided.
But many companies still make no concerted effort to reduce their ESG risks and some even try to reduce their compliance with rules and regulations or comply only with the minimum requirements in an effort to save costs. And that may turn out to be a truly short-sighted strategy.
Who are the main culprits?
Research from the University of Virginia has investigated the number and severity of ESG-related incidents across a large number of companies in the United States and Europe.
First, they found something that I find somewhat surprising. While companies in the mining, energy, and power sectors tend to get the most attention on ESG incidents, they are not the main culprits. The number of incidents in the manufacturing sector is much larger, though the average severity of the incidents is somewhat lower.
I guess it is the fact that if a mining company blows up caves on aboriginal lands or an oil company spills the groundwater of a township it is so much more intense and impactful that it makes the news and sticks in our memory. But if a retailer violates minimum wage rules or an industrial company skimps on health and safety procedures in its factors that is just not spectacular enough.
Number and severity of ESG incidents by industry
Source: Glossner (2021)
How severe an incident is does make a difference to investors as well. On average, smaller incidents create only a small stock market reaction but once incidents cross a certain threshold, share prices react much more.
Average share price reaction in the four weeks around an ESG incident by severity
Source: Glossner (2021)
Smaller incidents go unnoticed
But what investors really should pay attention to are the many small incidents that often go unnoticed. The research showed that companies that had many incidents in the past are more likely to experience more incidents in the future and are more likely to experience more severe incidents as well. In essence, companies with a lackadaisical approach to health and safety tend to get away with it for a long time, always experiencing small but not very costly incidents. But one day, an incident may not be so small anymore. Or the many small incidents may add up to a large cost.
Indeed, one major result of the study is that companies with many ESG incidents tend to experience lower profitability and larger share price drops at the next earnings announcement. Because most analysts and investors don’t pay much attention to these small incidents, they tend to ignore them in their forecasts. As a result, the forecasts for profitability tend to be overly optimistic and when the reality check eventually arrives, the costs of these incidents tend to lead to negative surprises — with correspondingly larger losses for investors.
The lesson to learn
The lesson for analysts and investors alike when considering ESG risks is to really pay attention to these small events and look at the number of past events. In many instances, the past is prologue and a high incident rate in the past will be a predictor of high incident rates in the future and correspondingly lower profitability.
JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.
If you are younger than 65 right now and live in a developed country, you have a problem. On the one hand, you know that your society is ageing rapidly and that means that the dependency ratio (i.e. the number of working age people who have to finance pensioners) increases rapidly. This will either lead to a reduction in social society and pension benefits over time or to higher taxes on both the working age population and pensioners. Either way, your expected net income after taxes declines, and your lifestyle is increasingly threatened.
The two ways to deal with this problem are either to accept a lower income and a reduced lifestyle or to save more. But with central banks introducing zero interest rates everywhere, saving more has become increasingly difficult because even if you are able to save more today, the savings just aren’t growing like they used to.
It is not clear which one of these forces will win in the end, the incentive to save more due to an ageing society or the incentive to save less due to lower interest rates. In this respect, studying the example of Japan, which has a head start of about two decades on the situation in Europe and the United States can be very informative. And when it comes to savings behaviour, the verdict is pretty clear. After two decades of zero interest rates, savings rates in Japan have plummeted.
Savings rates and monetary policy rates in Japan
Source: Latsos and Schnabl (2021)
I find it hard to believe that the outcome in Europe or the United States should be any different. People really don’t like to save for the future and if the incentive to do so is reduced through lower interest rates they are all too willing to spend their money today, rather than save for tomorrow.
The problem of course is that this aggravates the problem for pensioners since they now face an ageing society and lower savings than their parents and grandparents. The Japanese are solving that problem in a very simple way. They have managed to turn around the trend in the dependency ratio. Since about 2015, the dependency ratio is declining again in Japan.
Dependency ratios in Japan are declining again
Source: Latsos and Schnabl (2021)
The solution in Japan is simply that the employed population is growing fast again. And no, it is not through higher immigration, but through older people re-joining the workforce at age 65 or older.
Obviously, this is not some romantic version of being active and productive in old age. Most of the time, older Japanese have to go back to work in some minimum wage jobs just to make ends meet. And with more and more older people being forced to go back to work the wages for these jobs are coming increasingly under pressure. Japan faces an increasing income inequality without any meaningful immigration or outsourcing of manufacturing jobs to emerging markets. I wouldn’t be surprised if, in ten or twenty years, we in Europe and the United States would face the same problems. And I wonder how populist politicians will blame them for the lack of opportunity and income growth of the working class.
Of course, demographics is NOT destiny, as I always say, so the example of Japan is not a necessary result of the current developments in Europe and the United States. But we had better start thinking about solutions to this problem today, to be able to fix it. Because it will be pretty hard to manage rising income inequality and declining real wages if you can no longer blame outsiders for your problems but have to pit different parts of your own population against each other.
JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.
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Comments Off on Can ANY adviser add consistent alpha?
As we’ve explained many times, very few managers succeed in beating the market in the long term, net of fees. But what about those who select the funds for their clients to invest in, namely financial advisers and consultants? Many advisers and consultants claim the ability to add consistent alpha consistent. So is it actually true?
PRESTON McSWAIN and JOACHIM KLEMENT discussed this question candidly on a recent call. Here are extracts from their conversation.
Preston: Can we actively add consistent alpha? This is a question that is on the mind of many inside our industry. As advisers or investment consultants, we all want to be active and add value in terms of performance net of all fees.
In my experience, the problem often comes down to this: How do we do it, especially at scale? When a manager or advisor is small they can be nimble and have an edge, but as they grow…?
Klement: Agreed. Studies show this. Size or capacity can be a real issue with managers, especially in some of the areas that offer the largest opportunity for alpha, such as small or micro-cap stocks.
Preston: A problem can also be the size of the advisory firm or consultancy.
Not only do you have to find the managers at the correct time in a market cycle, when their style of investing is in favour, which is no small task.
You have to also be able to fund them without impacting the manager’s size in a way that reduces their edge. Less is more and scale is your enemy.
As an example, say you are allocating or managing only $1 billion. I know this sounds crazy, but it can be small potatoes, especially as it relates to investment consultants that work with pension funds, endowments, family offices, or high-net-worth individuals.
Klement: Yes, a billion can be very small.
Preston: Yep. Crazy indeed but that can be the reality. Say, for example, that a client hires an investment consultant to invest $1 billion across various asset classes with managers that will add alpha.
The consultant wants to add value net of their fees, but they also understand this. First, smaller is better. Secondly, managers need to be contrarian and can’t follow the herd. And thirdly, allocations of less than 5% don’t move the needle.
Klement: Agreed, again. And let’s pull on that last one just a little.
Preston: Good.
I threw out 5% but in reality, to make meaningful impacts on a portfolio, a 5% allocation may be too small.
Klement: Yes, even if you knock the lights out, a 5% allocation doesn’t move the needle. Let’s assume we find a manager that we think can consistently outperform a benchmark by 5%. This is a big hurdle to start, but let’s put that aside for now. We like the manager but we want to show prudence, so we only allocate 5% to the manager.
Preston: Well, a 5% outperformance hurdle is very big for sure. I’m not sure that I’ve ever seen someone who can consistently find managers who can consistently add 5% over an appropriate best fit index. Even if it could be done, though, it is not enough.
Klement: Exactly. You find the holy grail, but you only have a 5% allocation.
The math is that a 5% allocation to this exceptional manager only adds 0.25% of alpha to the total portfolio. It’s not much more than noise.
Preston: And there it is. Scale is your enemy – you know this. To make an impact, you need to realistically make 10% allocations, which on a billion dollars is a $100 million manager allocation.
Say you find a new micro-cap manager that you and your team are excited about. You want to give them money, but you know that $100 million of new money, especially over a relatively short time period, is highly likely to negatively impact the ability of the manager to outperform in the future.
Klement: Indeed. And you might be able to allocate $100 million for one of your clients, but you don’t just have one billion dollar client. If you invest in the manager for just one of your clients, which one?
Preston: You give the idea to just one client, you’ve played favourites. You have an ethics issue, at least. On the other hand, you give the idea to all your clients and you might blow the manager up and eliminate their ability to produce alpha in the future.
I’ve also discussed this in the past with friends who make decisions on adding new managers to separate account wrap platforms at large investment houses. They want might want to add a new manager, but are often concerned about overwhelming them.
Klement: Yes.
Preston: What would you say is the capacity or assets under management limit for an active micro-cap manager?
Klement: This is hard to get just right but, if I were really looking for consistent alpha, I would start to question a manager’s ability to add alpha if their fund or limited partnership gets bigger than $500 hundred million.
Preston: Back to our $1 billion client example… To move the needle, you would like to make a 10% allocation, which is a $100 million cheque. You know that this might seem large to your client, however, and might impact the manager. So, you dial it back to 5%, which is $50 million.
Klement: And it starts. Now do the manager side.
Preston: OK. Like you, I’ve been on the asset manager side before.
The consultant calls and says that they don’t only have one new $50 million account for you, but multiple ones. At first you are ecstatic. You are a small micro-cap manager and this will make your business AUM growth numbers for multiple years.
Then you think, How are we going to do this? The amount of money will not only impact the portfolio, and potentially trading and operations, it might mess up your composite numbers, because you might have to hold cash for longer than you would like.
So, you call the consultant back, thanking them for the opportunity – big time – but then ask nicely if they could roll the money in over multiple quarters.
Klement: Yes.You get a big cash spike and you know that your nice alpha numbers in your performance composite presentation are likely to go away.
Preston: Right. We all have this problem. We know how to be active. As we talked about last time, though, there’s always a “but” somewhere.
Klement: Yes, as you said before, the “but” is size is your enemy.
As you get larger you become more like the herd. And, paraphrasing a line from one of Howard Marks’ books: “You can’t do the same thing as everybody else does and expect a different outcome.”
If you are in the active world, you have to stay away from the herd and you don’t want to be a sheep. If you do this, though, it is not scalable.
Preston: The problem is twofold. Consultants can’t allocate small dollars.
And managers don’t want to stay small.
Klement: Exactly. Both are businesses.
Preston: Yes, other real life issues. Both investment funds and consultants need to run efficient businesses. Scaling up is good for business but can be bad for returns.
Klement: Scale or capacity can also be issues across a total client portfolio.
Everyone wants top performance, but the desire to be diversified and to control risk is also high. Because of this, money is spread around to multiple managers across multiple asset classes.
Preston: This brings in other issues that increase expenses and reduce efficiency. The total cost of tracking all the managers, public and private, can get high in terms of both time and treasure.
Klement: This is a big problem that even the large sovereign wealth funds are having. They want to do more in privates and venture, etc..
But they have capacity constraints as it relates to proper staffing and resources to stay on top of it all.
Even just being able to understand what allocations really are and what their performance has really been is a big and growing issue.
Preston: I often call it the three Ts: time, treasure… and the biggest one of all, tension. Not long ago I was talking on a panel with head of private investing for one of the largest family offices in the US. The person has a growing internal staff, which costs over five million per year, which does not include potential incentive bonuses that can be based on performance, similar to carry.
In addition, they also employ outside researchers and consultants.
Just the private investment part of the family office is a business unto itself, which the person said took them years to build and takes a good amount of time to manage.
Next, I heard this quote from the Chief Investment Officer of a large public fund on one of their calls. The CIO basically said this: “Private equity and venture are the only asset classes where we are committing capital before we understand what our exposures are really going to be. It then takes us 10 years to get fully invested and then another ten beyond that before we understand what our returns have really been.”
Klement: Yeah, it’s crazy. And gets even worse if you go into direct deals. They often take even longer for you to figure out what your returns are.
As your person said, it might take a year or more to build a proper team, which costs a good amount, and that is before you even invest much.
Then you have to consider all the costs of the private investment managers or deals, and your costs to track all investments and produce performance and exposure reports.
The inefficiencies of allocating to multiple managers and private investments can become quite high. It’s a heck of a lot. Oh, and if you concentrate too much, it is like gambling. It can be fun and stimulating, but the odds are not in your favour. Like the Vegas house, it’s the Street that wins.
Preston: Back to where we were before, maybe you can add value, but small is your friend. Small doesn’t win you a lot, though.
Klement: You’re right. You’re absolutely right.
Preston: You know, we all want to believe we can make a difference and add consistent alpha.
A few years ago, I wrote a piece, Say it Ain’t so, Joe. Like you, for the majority of my career I believed that managers and manager selection processes added significant amounts of value or alpha. After stepping back and looking at the independent evidence, though, I often feel like that little kid in the Field of Dreams movie looking up at his idol, Joe Jackson, and saying, “Say It Ain’t So, Joe.” Say it ain’t so, Joachim. Say it ain’t so.
Klement: I wish I could. As we have discussed, the problem is both a scale and market cycle one. Fund managers tend to be good in either bull markets or bear markets, but not in both across a cycle.
Let’s say you find a manager that has a track record that looks good over 10 years, as markets generally rise. When you look closer, though, you tend to find that many managers are just high beta plays. So, you have to ask yourself, Am I willing to pay a manager 1% or more in annual fees to get one point or so, when I could just add leverage to an index fund and come out the same or better?
Preston: You see this for sure, especially when looking at rolling period relative performance trends and performance consistency. You’ll find what seems to be a top performing manager, who is certainly hailed in “top” fund lists or in their own presentation materials, which are all from Lake Wobegon.
You then open up the hood and find, let’s say, that the fund has been concentrated in technology.
On the one hand, you can applaud them for the bet. On the other, when you compare them to a technology index, they don’t look so great. Finally, you then have to ask if their ability to win with concentrated sector or name bets is sustainable.
Klement: That’s the problem. Like what we experienced in the 90s. The stars were all the ones that went into dotcom stocks. It all can look good, until it doesn’t.
Preston: Yes, indeed.
Klement: So, where do we go from here, when adding consistent alpha is so very difficult?
Preston: That is the big industry question. Maybe we just need to be more open — more transparent about our ability to find the best of the best at the correct time and, if we do, about our ability to right size them.
It’s not that investors shouldn’t try and that we shouldn’t keep a lookout for opportunities. How about just being more candid that the odds aren’t that great, especially at scale, and that costs are high?
Klement: I totally agree.
PRESTON McSWAIN is the Managing Partner of Fiduciary Wealth Management, based in Boston, Massachusetts.
JOACHIM KLEMENT is a London-based investment strategist.
This transcript was first published on the FWP blog and is re-published here with permission.
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Comments Off on Transparency is good for business for asset managers
By JOACHIM KLEMENT
Fund managers around the world are increasingly facing new regulations that will require them to disclose more information on the climate-related risks of their investments, as well as their fees and charges.
Talking to both fund managers and executives of businesses on these disclosure regulations, I encounter all kinds of reactions ranging from “I don’t have time for this. It makes no sense and is just an additional burden” to “Great, let’s get ahead of the crowd and be transparent about our fees and climate-related risks before everybody else does.”
As an investor, I always prefer more transparency, but from the perspective of a fund manager or a company executive, does it really make a difference to be more transparent? In a word: yes.
New research from Japan
That is the conclusion from a new set of experiments by Satoshi Taguchi and Yoshio Kamijo who asked people to participate in a set of trust games. In these games, participants (investors) were asked to hand over a portion of their money to another person (the executive) who uses this money to invest in a project. The executive can get either a high return or a low return on this project. Once the return has been achieved, the executive can then decide how much money to give back to the investors (i.e. how high the dividend should be).
The interesting thing is that the level of productivity and thus the return of the investment of the project is only known to the executive. Thus, the executive can either decide to not disclose the level of productivity of the project or voluntarily disclose the level of productivity of the project. Naturally, if the executive knows that the project doesn’t create high returns, she is likely to not disclose that information and if the executive knows that the project is going to be highly profitable, she is likely to voluntarily disclose that information to the investor.
However, the researchers also used some modifications to create other states. First, they simulated a situation when the information about the productivity of the project would be unintentionally disclosed (i.e. through an information leak) or situations in which the executive could not choose to disclose or the information, good or bad, had to be disclosed to the investor. Finally, in a fifth setting, the investors could ask the executives for the information and the executives could then voluntarily disclose the information based on the demands of investors.
The chart below shows how much money of their initial endowment of ten units the investors chose to hand over to the executives.
Greater disclosure, higher investment
Note how trust in the executive builds up, the more transparent the executives become, and the more information they disclose to the investor. If the executive refuses to disclose vital information about the project, investments are low. If the executive cannot choose to disclose or not disclose the information investment gets a bit higher. It is a situation where investors are willing to give executives some benefit of the doubt and thus invest a bit more.
But note how investment increases once information about the project is disclosed. If the disclosure is unintentional (e.g. mandated by regulators) investments already jump compared to the situation where the information is not disclosed. But executives who voluntarily disclose the information receive an even bigger share of the portfolio of the investors.
Finally, if the investors ask for information and executives then voluntarily disclose it, investments are highest.
Transparency builds trust
What is going on here? In basic terms, deeper interactions between investors and executives build a deeper level of trust. By virtue of these interactions of asking for information and then receiving it, an additional layer of trust is built which drives higher investments.
Unfortunately, most investors never dare to ask for vital information or don’t have access to executives or fund managers to ask for it. Thus, the best course of action for fund managers and executives is to voluntarily disclose information about their businesses and funds.
The basic rule here is the more you disclose, the more your investors will trust you, and the more money they will invest.
JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.
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