Management of active risk budgets relevant for YFYS requirements can be challenging when also seeking to build Responsible Investment solutions. Utilising a diversified quantitative approach can deliver better risk adjusted and absolute retruns relative to a simple Index Reweighting approach or a Minimum Tracking Error Approach.
A common implementation of responsible investment principles for equity portfolios is to exclude companies with involvement in unwanted activities. The activities to be excluded are at the predeliction of the asset owner, but can span many areas such as the manufacture of tobacco & controversial weapons, involvement in gambling, pornography, alcohol, pork products and IVF as well as climate related issues such as coal mining and greenhouse gas emissions.
Within the context of the Australian market, the particular choice of exclusions can have a major impact on relative performance, potentially risking a fund to run foul of the Your Future, Your Super (YFYS) performance test. The resource intensive nature of the Australian market makes the targeting of fossil fuel extractors and users a notable challenge. The concentrated nature of the market further exaccerbates this challenge particularly when adding in other criteria to the exclusion list. It is not uncommon for exclusion lists to carry over 20 companies from the ASX300 with an aggregate index weight of over 15%.
The purpose of this paper is analyse the impact that a typical responsible investing screen would have over the 22 year period beginning in 1999. We exclude companies with material involvement in fossil fuel mining, manufacture of tobacco or alcohol and involvement in gambling.
We show that:
Our analysis spans the period from 31 December 1998 to 31 August 2021: just over 22.5 years.
A chart of the current exclusion list (31 August 2021) is shown in Chart 1. The size of each box corresponds to the current ASX300 weight.
The list currently comprises 22 members of the S&P/ASX300 Index with an aggregate weight of 13.4%. BHP with an index weight of 7.3% is the largest single exclusion. The exclusion list changes through time not only due to changes in index membership but also company activities. The current list may materially change in the near future given that South32 has divested its coal assets in recent months and BHP is due to divest its petroleum assets to Woodside in 2022.
Over the analysis period we identify approximately 17% of the ASX300 investment universe as being excluded on average. From 2008-2011 the exclusion list included up to 25% of the S&P/ASX300 benchmark weight. Over the course of our 22 year analysis period the ASX300/All Ordinaries Index has included British American Tobacco (BAM) and brewers Fosters and Lion Nathan to name just a few companies which have come and gone from the benchmark. Coal miners such as Centennial Coal (CEY), Macarthur Coal (MCC and Gloucester Coal (GCL) have all spent time within the ASX300 index.
While we concede that there could be other companies added to the exclusion list at this time, the focus of our analysis is on the active risk and return implications of an exclusionary approach. While the risk and return drivers are driven by specific exclusions list, our analysis and outcomes remain robust as long as a reasonable investible universe remains from which to construct a portfolio.
The decision to exclude securities is, in a sense, simpler than the decision of how to reallocate the excluded capital. There are three broad choices in how to reallocate capital:
Approach: Simply reinvest the capital in line with the index weight of the included securities
Pros: Simple, transparent & easy to calculate
Cons: Riddled with unintended risks and large relative performance differences
Approach: Use a risk model & optimise the weights for the included securities to minimise the exposures to risk factors realtive to the standard benchmark as much as possible
Pros: Reduces tracking error and exposure to risk factors (but cannot eliminate them)
Cons: Relative return expectation remains at zero – there is no return compensation for the risk taken
Approach: Incorporate a return expectation into the optimisation objective (Enhanced SRI) using an alpha (stock selection) model and risk model to choose weights such that the risk taken is offset with return expection
Pros: Relative return expectation is positive
Cons: Least transparent of the approaches requiring both stock selection and portfolio construction / risk management capabilities
Table 1 shows the performance, risk and attribution statistics for each of the three reallocation strategies over the analysis period from 1 January 1999 to 31 August 2021.
These summary statistics highlight that the simple index reweighting method carries significantly higher active risk relative to the Minimum Tracking Error approach (2.42% vs 1.59%). Our analysis shows that this is a consistent feature across the entire analysis period.
What is both pleasing and possibly surprising is that the Enhanced SRI approach carries less risk than the Index Reweight portfolio. This highlights that the combination of a diversified stock selection approach coupled with risk control can work together to provide improved results. This is further showcased in the rolling 12 month and rolling 8 year relative returns being best for the Enhanced SRI approach which was also the only portfolio to meet the YFYS performance test.
The vast majority of the performance improvement for the Enhanced SRI approach is due to the stock selection strategy enabling the portfolio to load into desired style factor exposures consistently through time. If the companies within the SRI exclusion list is aligned with characteristics such as cheap valuation or high profitability or balance sheet strength or momentum then the residual assets will naturally be underweight these. If excluded capital is re-invested more into low growth or expensive assets then the resulting portfolio will also carry such a bias relative to the standard index. The Index Reweighting portfolio is totally agnostic to these risks and the Minimum Tracking Error portfolio simply seeks to return all unintended exposures of the exclusion list back as close to neutral as possible.
Looking more deeply into the attribution of these portfolios we can see that the bulk of the performance improvement comes from maintaining a consistent exposure to quality and momentum factors in the Australian equity market. The exposures and cumulative relative performance contributions for each approach are shown below.
The prior two charts show the active exposure (relative to index) for the Axioma Profitability and Medium term Momentum Factors. The Index Reweight portfolio (Blue) remains mostly underweight these well rewarded style factors both due to the stocks excluded and also because the reinvestment of this capital ends up mostly in Australia’s four largest banks. The Enhanced SRI portfolio has a more consistently positive exposure to these factors which are correlated with Redpoint’s Sustainable Quality, Price Action and Analyst Events disciplines.
The contribution from managing these exposures is shown below and highlights the benefits of incorporating a diversified stock selection approach when building responsible investment solutions to meet the YFYS benchmarking requirements. Ensuring that a portfolio maintains a consistent exposure to rewarded factors can still be achieved even if there are a number of securities excluded on SRI grounds. Furthermore, having a range of stock selection views on each stock in the investible universe enables improved portfolio selection and risk control over the long term.
Our experience to date is that each client has different perspectives when it comes to Responsible Investment solutions. Clients differ in terms of their preferences when it comes to exclusion, risk budget, ESG and positive impact such as investment in renewable energy utilities. These differences are then compounded due to the nature of the Australian equity market. This results in meaningful active risk for Australian equity portfolios and the drivers of those risks continuosly change through time.
A stock selection perspective can assist with improving trade-offs on an after-tax basis. Being able to identify stocks about to be re-classified as long term gains, identifying stocks in a short term loss position, ensuring that tax credits are held for the appropriate time frame and whether or not to participate in off-market buybacks can all add value in an after-tax sense and assist with meeting the YFYS performance test.
Management of active risk budgets relevant for YFYS requirements can be challenging when also seeking to build Responsible Investment solutions. This can be particularly difficult in Australian equities given the concentrated nature of this market and large exposure to energy and coal mining companies.
Redpoint seeks to provide clients with a clearer understanding of the the risk and return implications of different approaches to exclusions based approaches to Responsible Investment. This analysis shows that active risk is introduced both in the exclusion process and, if not properly managed, in the reinvestment process as well. Utilising a diversified quantitative approach can deliver better risk adjusted and absolute retruns relative to a simple Index Reweighting approach or a Minimum Tracking Error Approach. An enhanced approach can be further extended to also cater for after-tax considerations aligned with the YFYS benchmarking requirements.
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This document has been prepared by Redpoint Investment Management Pty Ltd (ABN 83 152 313 758, AFSL 411671) (Redpoint), the investment manager of the Strategy, in good faith (where applicable) using information from sources believed to be reliable and accurate and based on information that are correct and estimates, opinions, conclusions or recommendations that are reasonably held or made as at the time of preparation. All information is to be treated as confidential and may not be reproduced or redistributed in whole or in part in any manner without the prior written consent of Redpoint. GSFM Pty Limited (ABN 14 125 715 004, AFSL 321517) (GSFM), is an associate of Redpoint and is the distributor of the Strategy.
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