How ESG impacts on equities AND bond returns

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@cap: Matt Christensen

Evidence is mounting that ESG factors are positively correlated with investment returns and, perhaps more surprisingly, it is not just at the stock selection level. Sovereign bonds are also impacted by ESG factors at the country level.

New evidence is being presented by AXA Investment Managers throughout the region, as the diversified global manager introduces a new environment, social and governance (ESG) framework within the next year.

While many studies in recent years, including work by AXA IM and State Street Global Advisor’s research arm, State Street Associates, have shown positive correlations between corporate governance and stock returns, the impact of other ESG factors, if any, has been more difficult to firm up.

AXA IM is now looking to integrate its work on ESG factors across the spectrum of its $US 694 billion of assets under management, following the success of a pilot study based on the UK equity team’s $US16 billion under management.

From a manager’s perspective, Matt Christensen, Paris-based global head of responsible investment for AXA IM, says the research shows investors benefit most when their managers connect investment and stewardship functions – research, engagement and voting – in order to create tangible value.

With UK equities, similarities which occur in companies whose returns score in the top 20 per cent of the universe include:

  • Performance – hard key performance indicators (KPIs) which are aligned with strategy; KPIs which include financial, operational and ESG factors; management rewards underpinned by a balanced scorecard
  • Remuneration – long-term orientation; rewards for operational excellence rather than stock market performance; appropriate and challenging metrics; minimum shareholding requirements
  • Control – effective oversight of the CEO and senior management; non-executive directors who provide effective challenge in the execution of the company’s strategy
  • Employees – relatively stable workforce and management; a good health and safety record
  • Environment – identified environment impacts and risks relevant to their activities; improvement targets in place and performance monitoring
  • Board – an appropriate mix of directors with the right skill sets that evolve in line with company strategy; healthy turnover and succession planning; a composition which reflects workforce diversity and the firm’s geographic footprint.

Christensen said that boards which best reflected the geographical sources of the company’s revenue tended to perform better than ones which did not. This is a clear sign for countries such as Australia, for instance, that companies should have more board representatives from China and India, which are the country’s biggest customers in aggregate.

With respect to other asset classes, such as bonds, AXA IM’s work shows that countries which had the worst ESG records, using AXA’s factors, also had the lowest bond index returns between December 2004 and December 2011. The gap between the best and worst over the seven years is about 40bps. But the countries which performed worst in that period are from “Asia and Oceania” and “Asia Emerging”, which asks questions of asset allocation with fixed interest instruments in fast-growing regions.

Christensen said China was ranked 5.6 out of 10 compared with 5.9 for the emerging and developing economies median.

“Our rankings are used as a guide so this does not mean that because of the ESG ranking it follows that they will always be underweight,” he says. “In the case of China, some key weaknesses are on environmental issues as well as some governance factors.”

Previous work by State Street Associates has also identified that governance and stock performance were closely correlated but also showed only a weak connection between environmental concerns and returns and no connection for social concerns. And the environmental connection may have been because of the run on green energy stocks which took place during the study period.

Christensen says back-tests by AXA IM showed that “social performance, especially human capital” does correlate with economic performance by enhancing revenue per employee.

“Because it is often linked to business development – community initiatives, human capital management, product innovation – strategies focusing on social issues can be closely correlated to growth strategies and economic cycle, exhibiting high betas and significant positive alphas in periods of market lull,” he says.

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