The Analytic Investors team, alongside the broader Wells Fargo Asset Management team, believes that environmental, social, and governance (ESG) risks are risks like any others: They need to be understood, assessed, and managed. To date, numerous academic and industry studies have shown a systematic relationship between risk and high-level, bundled ESG scores. These “catch-alls” encompass a variety of topics, including a company’s policies around environmental factors, employees, society, and corporate governance.

While the relationship between such factors and realized return has been inconclusive and time-period dependent, the Analytic Investors team’s research shows that the relationship between risk—as measured by price volatility—and each of these measures has been statistically significant. Companies with poor ratings on these measures have had systematically higher levels of risk. Poorly rated companies have had a higher degree of uncertainty associated with their future earnings. This, in turn, typically translates into higher risk for their shareholders.

As with other risks, these ESG exposures can be measured and managed. The Analytic Investors team has found that a risk model built purely using ESG factors has the potential to explain the cross section of global stock returns. Our ESG model is complementary to more commonly used risk models that quantify risk as a function of industry and firm characteristics. More importantly, our ESG model can capture a dimension of risk that’s absent from the other risk models.

Recent market events following the arrival of a new, unforeseen pandemic have provided a unique opportunity to measure whether ESG is relevant in a crisis scenario. We can measure this by comparing the power of the ESG model in the crisis month with its history. If ESG exposures were not relevant, we’d expect the ability of ESG factors to explain return to be minimal in the month when the coronavirus crisis was first identified.

In Figure 1, we compare the explanatory power of the model in March 2020—the period associated with the coronavirus-related market reaction—with its historical average. Historically, ESG factors have been able to explain about 6% of the variability in returns. This may not sound like much, but it’s statistically significant and economically meaningful. For comparison, global industry factors can typically explain about 15% of the variation in stock returns. In March 2020, ESG factors continued to have the ability to explain returns, and the explanatory power increased from its historical average of 5.8% to 10.1%.


Source: The Analytic Investors team

Past performance is not a reliable indicator of future results.

A company’s ESG profile reflects the combination of a multitude of factors, and each of these factors can have a different impact on return. In Figure 2, we contrast the importance of the different ESG components in March 2020 with their long-run average. The Analytic Investors team’s ESG risk model is organized around 12 key themes that consume thousands of ESG factors and millions of data elements.

Source: The Analytic Investors team

Past performance is not a reliable indicator of future results.

Whereas historically each theme is roughly similar in magnitude, Figure 2 shows that March 2020 differed from history in that measures of board independence, diversity, and alignment with industry best practices explained roughly half of the model’s predictive power. Similarly, large increases in the relative importance of how a company treats people throughout the supply chain were experienced in March. Other large increases in March relative to historical periods include how well a company evolves its product development, marketing, and sales toward sustainable offerings; how much a company pollutes and its ability to transition toward alternative technologies that reduce environmental harm; and how efficient a company and its suppliers are at reducing consumption in the supply chain.

After the initial market reaction in March, in April and May we saw the rise in importance of factors such as how well a company integrates ethics into decisions and policies, its performance on equitable treatment of shareholders, and its commitment to integrating ESG considerations into company operations.

The ongoing crisis has increased investors’ awareness of the benefits of diversified portfolios—especially as new themes emerge that may not be aligned with traditional metrics of risk measurement, such as industry or company characteristics. Measuring and managing a portfolio’s ESG profile presents an opportunity for portfolio diversification and risk mitigation that should not be overlooked.

 

 

Disclosures: 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.

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