In today’s podcast, we will speak with Harindra de Silva, Ph.D., CFA®, Portfolio Manager for the Wells Fargo Asset Management (WFAM) Analytic Investors team, about how traditional risk—as measured by price volatility—may be improved upon by measuring and managing environmental, social, and governance (ESG) profiles within a portfolio.

http://on.wf.com/6122GPySr

Laurie King: Factor investing has some important insights for us about measuring environmental, social, and governance (known as ESG) risk in portfolios. I’m Laurie King and you are listening to On the Trading Desk®. Today, I’ll be talking with Harin de Silva, Portfolio Manager for the Wells Fargo Asset Management Analytic Investors team about factor investing—which is what Harin and the team at Analytic Investors are experts at and have been doing for 30 years.

We’ll be talking about the relationship between ESG factors and realized return, especially about how ESG exposures can be measured and managed. And let me tell our listeners that the Analytic Investors team has just published a blog at our website AdvantageVoice®, and it’s called Mind your E.S. and G.’s. Welcome back to the program, Harin.

Harin de Silva: Happy to be here, Laurie. Thanks for having me.

Laurie: To get started, I’m not sure if I have one or two questions to ask. First, you have found that a risk model built purely using ESG factors has the potential to explain a cross section of global stock returns. Can you tell us about your model, its findings, and also how it fits with traditional risk measures?

Harin: So what we’ve done here is build a risk model that’s very different from traditional risk models in that we are not using fundamental factors. We’re not using a company’s industry to explain returns, but rather we’re using how a company relates to its environment, how it relates to its employees, and how it’s governed.

And we basically use data on those three dimensions to explain some companies’ returns. And what’s surprising is how significant those factors can be in explaining returns and how the significance of that varies over time.

Laurie: Why was it important to look at ESG factors and see if they were relevant in a crisis scenario, as opposed to normal times?

Harin: Yeah, this is where the scientists in all quant finance guys comes out, right? Because this is almost a unique experiment where we’ve shut down the way the world normally works and we’re looking at the abilities of companies to operate profitably in this new environment.

And to us, this was a perfect almost lab experiment to see whether these factors would become more important or less important.

So you know, theoretically at least, a company which has good labor force, a nimble governance structure, should have an advantage in the type of environment we’re in, which is actually a complete surprise.

And what we’ve seen is that the importance of these factors in expanding returns actually doubled in the crisis period. So typically these factors explain about 5% of the overall volatility of the market. That rose to around 10% during the crisis period. Now that may not sound like much, but traditional industry factors explain a similar order of magnitude.

Laurie: And the crisis period you’re talking about is this coronavirus pandemic shutdown period, right?

Harin: Right, yeah. The period that started in March and April and in some ways continues until today.

Laurie: And in the blog, you wrote that your ESG model is organized around 12 key themes. How did you filter it down to focus on 12? And what were they?

Harin: So the themes are actually derived from the three larger themes of how a company relates to its environment, how it relates to its governance, and how it relates to social factors. And what we did is basically collect data from a number of different sources and basically use each of those data sources as an individual factor. So rather than taking the average, we basically try to capture, for example, under the social category, you can have a company’s community engagement, how it relates to human rights in its supply chain, how it relates to employee safety.

So those are all treated as individual factors and by using them individually, you’re not imposing that one factor can be more or less important than the other. What you’re doing is basically saying, let the data tell me which factors are more important and allow that those factor importance to vary over time.

Laurie: You know, I’m really amazed that you can look at something like “alignment with industry best practices” or “how a company treats people throughout the supply chain” and put a number on it. That is really great, and we know that investors increasingly care about ESG, but how do you do that?

Harin: Yeah, this is really a revolution in the data availability that’s happened in the last 10 years or so, where there’s a number of different providers that just don’t rely on annual reports. They actually crowdsource data globally from how companies in different countries treat their suppliers. They look at working conditions in the company’s factories. So all this data basically gets aggregated up, and then someone like us can basically take all this information and turn it into basically a risk model that captures how this data relates to stock returns.

So I would say 10 years ago, it was impossible to build this type of risk model, but with the growth and the availability of information, we basically have been able to take this information and build something that’s really useful from an investment perspective.

Laurie: And how does this information help an investor’s portfolio?

Harin: Well, what you’re able to do is basically position the portfolio so it has the potential to behave in a way that’s advantageous in the time of crisis or advantageous from the way the portfolio relates to the overall environment. So for example, you can tilt a portfolio towards companies that treat its employees well but do that in a very systematic way and also control the amount of risk that’s generated by the tilt.

Laurie: As we wrap up this episode of On the Trading Desk, do you have a takeaway message that you’d like to leave our listeners with?

Harin: I would. I think that as we built portfolios and as we invest, something to think about is the availability of all this new data. And when you listen to the way people look at a company, often this dimension—the relationship of a company with its environment—is often ignored, and I think this is a sea change that’s taking place and you’ve seen it to some degree right now with companies like Morningstar rating mutual funds based on their ESG ranking. I think this is going to be increasingly common, and I would predict that in 20 years from now, knowing a company’s relationship with these three factors is going to be as critical as knowing its industry or knowing who its competitors are.

Laurie: Well, that’s an interesting prediction. We will see. So thank so much for being on our show today, Harin.

Harin: Always a pleasure, Laurie. Thank you.

 

Laurie: For our listeners, if you’d like to read more market insights from Analytic Investors, you can find them at our AdvantageVoice blog. In the meantime, I’m Laurie King; take care.

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Disclosure: Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

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