Skeptics have voiced their opinion that some portfolio managers with stocks heavily weighted toward ESG metrics may have done well this year just because ESG stock selection kept them out of the energy sector.
For one, that’s not a viable option for institutional fund managers running a sector-neutral strategy or long-only with minimum and maximum sector weight constraints. For them, mitigating risk within their sector exposure is the alternative.
With that in mind, within the energy sector, we tested the performance of top quintile vs. bottom quintile (top/bottom 20%) constituent returns ranked on Refinitiv’s ESG overall score, compared to the overall sector cumulative return over the past two years. Top quintile (F1) returns are shown in green, bottom (F5) returns in red and the equal-weighted universe in blue. The backtest was performed using our cloud-based platform, QA Point powered by Elsen, with its easy point-and-click functionality built with traditional equity portfolio managers in mind (no need to code).
The spread between the top and bottom quintile for the S&P 1200 energy sector was 31.12 percentage points – a meaningful difference in returns. Additionally, the top quintile (best ranked 20% of the index sector) outperformed the equal-weighted returns of the sector constituents and the bottom quintile underperformed.
Exhibit 1: S&P 1200 Energy Sector Returns March 30, 2018 – March 31, 2020
Source: ESG Scores from Refinitiv, QA Point from Refinitiv Powered by Elsen
We also found good results using a larger universe within a global index of stocks. Using the TR Global index, the spread of cumulative returns among the top and bottom set of stocks was 22.34 percentage points.
Exhibit 2: TR Global Energy Sector Returns March 30, 2018 – March 31, 2020
Source: ESG Scores from Refinitiv, QA Point from Refinitiv Powered by Elsen
Turning to a more sector-related ESG factor, we tested the performance of the Refinitiv Emissions Score on a broad index. It also worked well at sorting stocks within the energy sector. The cumulative two-year top/bottom quintile difference was 30.91 percentage points. It generated an annualized top/bottom annualized return of nearly 24% with an attractive risk-adjusted return Sharpe Ratio and Information Coefficient (meaning it sorts stocks well across the entire range of scores, not just at the top/bottom tails). The top quintile significantly outperformed the overall energy sector universe and the bottom portfolio significantly underperformed. This measure would have worked well for both stock selection and risk mitigation purposes.
Consider its power as a risk mitigation tool. The bottom quintile of this index underperformed the sector universe by 13.28 percentage points, generating a -62.35% loss. This was 3.74 percentage points below the bottom quintile of the overall ESG constituents shown in Exhibit 1. Nearly half of this underperformance was generated in just the first quarter of 2020, further demonstrating its risk mitigation value during the recent market shock.
Exhibit 3: S&P 1200 Energy Sector – Emissions Score Returns March 30, 2018 – March 31, 2020
Source: ESG Scores from Refinitiv, QA Point from Refinitiv Powered by Elsen
Consider a couple of individual energy companies as examples, drilling into the details of their ESG component scores. Looking at individual U.S. energy companies ranked back in March 2018, Arch Coal ranked in the bottom 20%, at Fractile 5.
Exhibit 4: Arch Coal ESG Rank, March 30, 2018
Source: ESG Scores from Refinitiv, QA Point from Refinitiv Powered by Elsen
Examining its ESG details, Arch Coal now has an ESG Combined Score of D+, the same as it held two years ago at the start of our backtest period. It received low scores across all major Environmental, Social and Governance Pillars and for Emissions. Its Controversies Score also declined in the most recent period.
Exhibit 5: Arch Coal ESG Scoring Measures View
Source: Eikon by Refinitv
Exhibit 6: Arch Coal 1-year Price Chart
Source: Refinitiv Datastream
Its last 1-year price change was a decline of -63.64%, compared to -8.01 for the S&P 500. Year-to date, it has lost 54.25% of its market value.
In contrast, Hess Corp. received high marks across all major ESG Pillars and for Emissions.
Exhibit 7: Hess ESG Scoring Measures View
Source: Eikon by Refinitiv
Compared to the 64% loss in market value that Arch Coal has suffered, Hess has declined relatively less, at -44% over the last year. It also outperformed ARCH year-to-date by nearly 10 percentage points.
Exhibit 8: Hess Corp. 1-year Price Chart
Source: Refinitiv Datastream
Conclusion
Besides helping align portfolio construction to the values individual investors are increasingly seeking, ESG may also aid portfolio managers in avoiding downside risk in the security selection process. From a risk mitigation perspective, focusing on a sector-specific scoring measure such as Emissions for energy companies, shows even greater promise. Based on this study, it may be especially effective when a sector undergoes a sudden market shock.
