Social impact: Testing a new opportunity for institutional investors
- Social factors can be harder to define and assess than environmental factors – and climate in particular – but we think they can reveal corporate frailties and contain material risks and opportunities for institutional investors
- There are challenges, of course, but we think responsible investors have a few options for integrating social factors in portfolios, from integration with initial analysis to mitigating harm, and seeking a positive contribution
- We think it is possible to build a social-aware portfolio by using the UN Sustainable Development Goals to refine the investment universe, while preserving financial performance
The drive to deliver net zero emissions by 2050 has hogged the responsible investment headlines. Institutional investors interested in environmental, social and governance (ESG) factors have rightly seen climate as a huge priority and there was a risk this might create ‘carbon tunnel vision’, relegating other concerns to the sidelines. Happily, things are changing.
There is now a far greater awareness of the role social factors play in the pursuit of a Just Transition – one that acknowledges and addresses the broad impacts of climate change and the policy response. The COVID-19 pandemic and recent cost of living crisis have also reminded us of the powerful social themes in human capital management, health and wellbeing, and supply chain oversight. Simply put, we believe social factors can be a window to future corporate frailties and a potential flag for material financial risks.
Responsible investors are conscious of this but have been restricted in what they can achieve in what is a broad and disparate set of inputs. The clarity seen on climate is harder to pull into focus when a huge variety of social issues are in play. We believe, however, the tools now exist for asset managers and their clients to identify potential social risks and opportunities in portfolios and adapt holdings in an effort to reflect them.
A first step might be to focus on the potential financial benefits of making sure the ‘S’ forms an important part of the ESG analysis carried out by your asset manager. Social factors in supply chains and in employee relations can have direct and immediate effects on company valuations, and we think there are clear advantages in addressing this as investors seek to improve risk-adjusted returns. In fixed income, this is about avoiding defaults and downgrades – in equities it can be about improving alpha, or excess returns. To do it, investors might set exclusions criteria or tilt portfolios to issuers with better performance on social factors, as well as supporting active engagement that encourages businesses towards more sustainable practices.
Investors may then wish to apply a ‘do no significant harm’ principle to portfolios, involving the removal of issuers associated with the worst negative impacts from social factors. This would be from a purely non-financial perspective, although we would expect a risk mitigation effect and a close correlation with tail-risk ESG scores which we believe can be aligned with more resilient carried out by your asset manager. Social factors in supply chains and in employee relations can have direct and immediate effects on company valuations, and we think there are clear advantages in addressing this as investors seek to improve risk-adjusted returns. In fixed income, this is about avoiding defaults and downgrades – in equities it can be about improving alpha, or excess returns. To do it, investors might set exclusions criteria or tilt portfolios to issuers with better performance on social factors, as well as supporting active engagement that encourages businesses towards more sustainable practices.
Investors may then wish to apply a ‘do no significant harm’ principle to portfolios, involving the removal of issuers associated with the worst negative impacts from social factors. This would be from a purely non-financial perspective, although we would expect a risk mitigation effect and a close correlation with tail-risk ESG scores which we believe can be aligned with more resilient financial performance. This principle is gaining traction with regulators and forms a key pillar of the EU Taxonomy – European rules designed to define the activities companies can claim are climate-friendly.
A further enhancement of social integration in portfolios can be delivered through the pursuit of a measurable positive social contribution. This may involve favouring issuers with best-in-class social practices around things like gender diversity at board level or workplace accidents, even if a company is not directly involved in socially progressive business activity. Investment philosophy will play a role here: Do you believe companies that make a good social contribution will hold less risk over the longer term?
The fourth and final stage of the social investing spectrum moves into the realm of pure ‘impact’. At this point investors can consider social and sustainability bonds as well as companies where the social impact is deliberate, genuine and measurable. It also opens up the possibility of detailed key performance indicators (KPIs) that offer alignment with the Sustainable Development Goals (SDGs), the United Nations targets that are helping set the direction and drive the momentum for countries and investors alike.
To integrate social factors in portfolios, whichever approach is favoured, we need appropriate metrics. In this social space, that throws up some intriguing challenges, compared to our now familiar climate-related metrics:
- Uniformity: The S in ESG is a many-headed beast. Everything related to staff, suppliers, consumers and other stakeholders contains a social element, as do many of the factors primarily considered as environmental concerns. The dispersed nature of social factors risks blurring the focus or forcing compromises between them. Contrast this with the single and specific goal of achieving net zero by 2050 and the uneven approach to social investing is unsurprising.
- Unity: Whereas climate and net zero enjoy a relatively strong consensus between governments, investors and consumers, the picture around social is less joined up. Investors are steadily getting there, and many consumers are already thoroughly engaged, but we believe policy and regulation often struggle to properly address the many and varied fragilities at play in social – partly due to the lack of uniformity described above, and partly due to the political challenges involved.
- Urgency: Climate change is now understood as a clear and present danger. The timeframe has been established and the need for action aligned with that goal. Social effects, however, could take longer to emerge and be attributed to multiple factors. Some effects will be immediate, but may be related to an individual issuer, such as in the handling of human capital.
So how can investors address these challenges? We think the 17 SDGs offer a genuinely powerful framework that helps to overcome the issue of uniformity – it can be argued that most of them relate to social considerations directly or indirectly, often in combination with the environment. Their breadth of coverage and universality are precisely what is required if an investor wants to reshape a portfolio with the goal of either mitigating against social risks, or directly contributing to social good.
Scoring remains a combination of the qualitative with the quantitative – an inexact science – but we have seen that most issuers can be scored against most of the SDGs using third-party data and our own research. That delivers a scoring system that runs from +10 to -10 to cover both risk mitigation from potential significant harm and verifiable positive impact. A lot of issuers fall somewhere in the middle but importantly, standout problems can be identified, and it is becoming clear over time that regulatory requirements (e.g. the EU Taxonomy) may be mapped across the SDGs. We do recognise that these are a starting point in the social investing journey and the market will likely evolve over time – as in the case of climate investing.
Putting it to work in portfolios
As an illustration of how using the SDG framework could work in practice, we looked at the impact in the investable universe when excluding the worst offenders – and identifying any potential effect on financial results. Where that line is drawn is down to the individual investor, but in our sample analysis, we took the ICE BofAML Global Credit Index and excluded any issuer with an overall SDG score of below -5.1 We would consider this an appropriate ‘do no significant harm’ policy.
Using SDG scores to refine the universe
Source: Intercontinental Exchange, AXA IM 31/08/2022. ICE BofAML Global Credit Index (G0BC). For illustrative purposes only
That had some important effects. As one would expect, there is an improvement in the SDG scores – both the minimum individual SDG score and average SDG score increased, but what about the financial metrics? The yield to worst actually increased to 6.1% from 5.8% and the spread to government bonds was broadly unchanged at 172 basis points (bp) from 171.2 Our view is that these financial implications are negligible and can potentially be addressed using active management. This would allow investors to improve their social impact while aiming to maintain the desired financial characteristics of their portfolios. In addition, the exclusions allowed us 83% of the original investable universe while the average credit quality was unchanged. In our view, this shows that one is able to build a broad fixed income portfolio while also improving its social footprint.
Another illustration shows a possible alternative approach – including only issuers that achieved an overall neutral or positive SDG score. This ramps up the effect on all measures in our example. The average SDG score moves to +3.1 versus +1.1 for the universe while the investable cohort drops to just 69%. The yield to worst dips back to universe levels at 5.8%, and the spread again remains broadly unchanged. Again, we believe this effect on financial performance could potentially be mitigated by careful active management. More dramatic exclusions, for example removing any company that has a single negative SDG score, could have very damaging effects on future performance, so we advise caution on implementing harsh guidelines or restrictions unless investors are willing to accept potentially lower risk-adjusted returns.