Climate Week and ETF Systemic Risks
Week Ending 27 September

Over 200 separate events surrounding Climate Week, as well as the UN General Assembly, have made sure that Midtown Manhattan streets are gridlocked  this week – resulting in a virtuous cycle in which environmentally-friendly public transit and/or shoe leather are the only ways to get around.  We’d propose that this year’s events demand more attention from the IR population than in any prior year, with Climate Week representing the “E” and the UN the “S” in an ESG investing universe growing at a double digit pace.

So…here’s the latest news from both the ESG and non-ESG IR world.

- Finally. The Federal Reserve has passed down a decree that will forever end the fearmongering about the risks of the expansion of ETFs on the overall financial system.  Okay, yes, that sentence is dripping in sarcasm, this topic is not going away…but this study by the Federal Board of Governors does have some interesting by-products that matter to the IR profession. Fed researchers through both direct and meta-research find that asset flows into passive products are mostly independent from performance – so they’re not likely to exacerbate any sudden downturns. Separately, leveraged ETF products (i.e. the “3x Short ETF”) do contain some inherent risks, but they’re still a tiny fraction of overall assets, with only about $30b in equity funds sitting in leveraged ETFs. Finally, while the Fed does have some worries about concentrating assets in one firm (imagine if a major ETF provider were to fail as a business), it says concentration in asset management has only increased slightly over time, and doesn’t pose serious danger.  Don’t expect regulators to consider any action about the concentration in your passive shareholders unless the research starts to point sharply in the opposite direction.

- The Autocorrect covers ESG topics and quant investing in almost every issue… this is one of the first to kill two birds with one stone. The Financial Times published a piece this week discussing the latest hedge fund trend – “hunting for reliable ways of identifying stocks with strong or improving ESG characteristics that are likely to beat the market more often than not.” Citing data from Deutsche Bank and Global Sustainable Investment Alliance, the FT notes that  ESG fund assets are projected to triple from just under $50T this year to over $150T in the next fifteen years. Just as quantitative funds focusing on momentum and value factors have grown to underpin billions in assets, hedge funds such as Man Group and Caxton Associates have been putting their money to work to identify the fabled ESG factor in order to build similar, systematic strategies… the rewards for which could be significant. “Managers who can establish an ESG factor will have the best chance of sharing in the $33tn of assets managed under such mandates at the end of last year, up from $23tn at the end of 2015.” Man Group fund manager Jason Mitchell adds that the firm may have found an ESG factor earlier in 2019 – some inputs to their ESG factor model for you to consider: “a company’s policies on using resources efficiently; the fines it has been given; its workforce diversity; shareholder rights, and whistleblower protections.”  (Matt Courchaine)

IR Best Practices 

- The Autocorrect contributors are partially comprised of self-described finance nerds, for whom think-pieces about the gradual demise of GAAP are curiously both interesting and enlightening. Worse, from what we understand from talking to our clients, there’s a chance The Autocorrect’s readership contains even more finance nerds than our contributors. For those falling into this category, this piece authored by Marcum serves as a useful summary of the state of play in the non-GAAP discussion. 97% of companies use non-GAAP disclosures, according to an Audit Analytics study, but the article carries some gentle warnings for companies that rely too heavily on non-GAAP factors in describing their performance. Author Drew Bernstein reminds us that the PCAOB is already considering involving auditors more deeply in non-GAAP values, and that having a “non-GAAP policy” in advance that defines the types of metrics the company may want to report in non-GAAP form and the reasoning behind them may help build trust.

- Willis Towers Watson’s “Thinking Ahead Institute’s” research series on the evolution of asset classes includes a piece that covers both private and public equity, with a secondary theme on the growing opportunity for direct listings to help bridge the gap between the two classes.  But the article’s primary focus is on the potential for disruption in the private equity universe – with so much private dry powder charging such high fees for chasing so few opportunities, we appreciated one of the points on page 7.  There are multiple ways to access private investments, but one of the most cost-effective is to invest in public companies that consistently acquire strong private investments – either outright or through minority stakes.  Or, put another way, a company that has a strong track record of identifying, acquiring, and integrating private investments, might produce PE-equivalent returns with not only lower risk but also far lower fees.  We’ve maintained in this space that public companies should always present investors with a few “call options” that show the potential for strong growth even with some uncertainty – if you’ve built a strong M&A effort over time, it should be a part of your investment story. Over the long run, if PE isn’t providing the right return profile net of fees, public companies with a PE-style approach may cross asset class lines. 

- Climate Week in New York featured a wide range of events involving companies, investors, philanthropists, and activists (and is probably the reason you now know who Greta Thunberg is). Hence, ESG investing was top of mind at numerous events over the week – in one that stood out to us, Brian Deese, Global Head of Sustainable Investment at BlackRock, shared his thoughts on his company’s positioning for climate change and ESG strategies at an event put on by the Institute for Policy Integrity, entitled Paying For It: Estimating and Responding to the Costs of Climate Inaction  (full event). BlackRock’s sustainable investment team’s report called Getting physical: assessing climate risks can be found here.

Deese suggested that risks already exist in the market today, and investors can project scenarios forward to predict future risk. Interestingly, and what may be in contrast to other investors’ approaches, when developing ESG strategies, BlackRock looks to be industry neutral and identify relative underperformers and outperformers in each industry, instead of excluding specific industries. BlackRock has 59 new sustainable products, which are fastest growing in Europe, including a recently launched low carbon index fund. With the introduction of these new funds and an increased focus on ESG, the company plans to engage more with issuers on how to mitigate risk and drive changes.  If you’re planning on talking to Blackrock during engagement season – the report and presentation are good preparation. (Sarah Hodash)

- Banks took center stage in Climate Week this year, with an organization of the largest banks publicly signing on to a set of Principles for Responsible Banking. These Principles aren’t deeply prescriptive to banks’ day-to-day business, mostly focusing on suggesting a set of targets that each company can pursue.  However, it again brings to mind a conversation we’ve had in this space from many different angles that has parallels to the impact investment / green bond movement. There are likely small-scale investment opportunities with an environmental or social benefit inside your organization, and each of the bank signatories that have stated targets will be looking for ways to commit capital to help meet them.  Identifying these projects and seeking discrete funding for them might have benefits not only for your business and the stakeholders you face as an IRO, but now also for the banks financing them.

Questions? Comments? Will they need to pry your HP 12C from your cold dead hands? Reach out to your IHS Markit team, or