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The missing link: why ESG should be in investors’ risk DNA

Home / Perspectives / The missing link: why ESG should be in investors’ risk DNA

Eoin Murray, Head of Investment
14 November 2017
Macro Economics

Risk morphs, and investment strategies must evolve in response. We have expanded our set of analytical metrics to include environmental, social and governance concerns to gain an even broader view of the changing environment – and to learn what adaptations we must make next.  

As experienced investors know, risk takes on many forms.

Over the course of many decades investment professionals have categorised several varieties of these distinct market animals. In probabilistic exercises, they have pinned down their essential characteristics like butterflies in display cases.

While museum-quality historical examples serve a useful purpose for market observers and participants, identifying risks in the wild requires a more sophisticated set of tools.

We have met this challenge with our ever-evolving five-factor analysis matrix, which aims to capture the often-subtle signs of incipient risk from multiple observation platforms. Our five core vantage points – covering volatility, correlation, stretch, liquidity and event risks – have been regularly supplied with new viewing tools to improve the quality of data collection and analysis.

For example, we recently introduced a new take on volatility via our Complacency Indicator, while adding statistical power to liquidity risk measures by bringing ‘Kyle’s lambda’ to bear on the raw data.

This quarter, however, environmental, social and governance (ESG) analysis emerged as a new stand-alone genus within our range of risk species.

Including ESG factors marks an evolutionary jump forward from a formal risk analysis perspective. But in the context of our wider investment strategy, the move is not so surprising. ESG has become such a central component of how we (and many of our clients) think about investing, that including it now seems part of a natural selection process.

In practice, we believe that ESG analysis provides investors with another, potentially lucrative, method of managing portfolio risk. Given the broad terrain of the ESG field, we plan to tackle specific areas of interest each quarter, starting this quarter with a look at a few ground-breaking studies on climate change.

We covered subjects as diverse as how different food crops would cope with rising global temperatures, where ‘tipping points’ were most likely to occur, and how corporate incentives impact carbon-reduction targets.

We can use studies like these to help gauge the relative exposure of companies to climate change risk.

Markets calm, but surface tension rises

But this new focus on ESG risk has not blinded us to the traditional range of indicators at our disposal. Curiously, in a year riven with political and monetary angst, financial markets appear to have maintained a carefree attitude.

Most of our risk measures have barely blipped during 2017 despite roiling political crises and the beginning-of-the-end for unconventional monetary policy (UMP) globally.

However, unusual correlation readings, the tightening stretch risks in multiple asset classes, and the ongoing liquidity watch (especially in bond markets) support our generally cautious stance.

If we are indeed headed for a correction of some sort, then understanding your investment timeframe is paramount: depending on how your portfolio has adapted to your time horizon may well represent the difference between calamity and opportunity if risk runs wild.

In summary, our six-factor risk analysis suggests:

Volatility: Levels must pick up from current low levels soon

Correlation risk: We concur with the JP Morgan investor note, published in September, that warned: “Over the past two decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of accommodation, this assumption will most likely fail”1

Stretch risk: Different market variables get tighter and tighter – in the face of greater leverage (as a result of lower volatility), we can only hope that the inevitable unwind will be orderly

Liquidity risk: Liquidity concerns have refocused back on the bond markets, with other asset classes representing a lower chance of liquidity-sourced contagion

Event risk: The focus seems to have shifted from political and policy uncertainty back to economic conditions, which for the time being suggest modest growth. Look for those conditions to wobble as the unwinding of UMP takes a firmer hold

ESG risk: ESG risks are for real and for now – investors have the opportunity to incorporate them in their decision-making.

For our full analysis of the current risk environment, read the latest issue of Market Risk Insights.

  1. 1 JP Morgan, ‘The Great Liquidity Crisis’ investor note, September 2017
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Eoin Murray Head of Investment Eoin is Head of Investment and a member of Hermes’ senior leadership team. Eoin also leads the Investment Office, which is responsible to clients for the investment teams’ consistent delivery of responsible, risk-adjusted performance and adherence to the processes which earned them their ‘kitemarks’. Eoin joined Hermes in January 2015 with over 20 years’ investment experience. Eoin joined from GSA Capital Partners, where he was a fund manager. Before this, he was Chief Investment Officer at Old Mutual from 2004 to 2008 and also held senior positions at Callanish Capital Partners LLP and Northern Trust Global Investments. He began his career as a graduate trainee at Manufacturers Hanover Trust (now JPMorgan Chase) and subsequently performed senior portfolio manager roles at Wells Fargo Nikko Investment Advisors (now BlackRock), PanAgora Asset Management and First Quadrant. Eoin earned an MA (Hons) in Economics and Law from the University of Edinburgh and an MBA from Warwick Business School. Eoin is a Freeman of the City of London, and a Liveryman of the Worshipful Company of Blacksmiths. He is a member of the Exmoor Search and Rescue team, a fully qualified Swift-water Rescue Technician and a Flood Water Incident Manager.
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