Are investment horizons preventing integration of ESG factors?

During the joint CFA Institute-PRI workshop series on ESG integration, participants from around the world made similar observations about the nature of ESG factors:

• ESG factors are long-term drivers of returns.
• ESG factors can influence market prices over the long term.
• ESG events are one-off, large-impact events that are difficult to predict but that increase in likelihood as the time frame increases.

These observations suggest that ESG integration is less relevant to investors with a short investment horizon. In fact, some workshop participants suggested that ESG factors come into play when the investment horizon is a minimum of five years, making them material to long-term investors only. But is that true?

Why long-term, not short-term factors?

Several reasons are often given when investors state that ESG factors are long-term and not short-term factors. One point often made is that conventional financial factors have an overriding influence on prices, especially in the short term. A participant of our workshop in France stated that returns are less likely to be driven by long-term ESG factors and are more likely to be driven by short-term factors, such as supply and demand, sentiment, financial news, quarterly results, broker recommendations, political factors (e.g., stability of government), and economic indicators.

Workshop participants across several jurisdictions, however, believe that ESG factors are positively influencing share prices and bond prices in the short term as well as in the long term. During the Frankfurt workshop, a participant said that ESG effects on the upside tend to materialise through a series of incremental upticks that individually contribute to long-term investment return.

Sudip Hazra, head of sustainability research at Kepler Cheuvreux, points out that “sometimes what we are looking at in the long term is a series of constructive short-term decisions, not just one long-term decision which is static. Overall we see more demand for a holistic view of sector drivers which include ESG risks and opportunities, with more focus on long-term outperformance rather than explicitly short-term timeframes.”

Sometimes what we are looking at in the long term is a series of constructive short-term decisions, not just one long-term decision which is static

Sudip Hazra, Kepler Cheuvreux

Even with the downside, there can be short-term incremental impacts on market prices. Benjamin Yeoh, CFA, senior portfolio manager at RBC Global Asset Management, highlights Carillion as an example,

”Carillion, which went bankrupt, actually died a death of 1,000 cuts over the three years preceding that. You could talk about whether it was culture or all of those other things, but if you crystallise a lot of the problems as being on the ESG risk side of the matter, then actually you had a long, drawn-out, multi-year destruction of value before we had a very abrupt complete destruction of value.”

If you crystallise a lot of problems at Carillion as being on the ESG risk side, then actually you had a long, drawn-out, multi-year destruction of value before we had a very abrupt complete destruction of value

Benjamin Yeoh, RBC Global Asset Management

Long-term factors turning into short-term factors

Another argument often made to explain why ESG factors are long-term factors is that ESG factors, ultimately environmental and social (E&S) factors, are not material now, but they may influence market prices in three years, five years, or longer. This argument is slowly being eroded as ESG investments now have moved into the mainstream arena and as more practitioners have identified ESG factors that they are already  analysing. According to a survey of 1,100 CFA Institute members, 23% of respondents believe that both E&S issues had often or always affected share prices in 2017 (see table below).

Respondents acknowledged that E&S factors are likely to be more material in three years’ time, which was demonstrated by 52% and 46% of respondents believing that E&S issues, respectively, will often or always affect share prices in 2022, an increase of 29 and 23 percentage points respectively on 2017 figures.

Investors, however, are demonstrating the short-term impact of ESG factors on their portfolio holdings. Investors regularly point out that securities can be exposed to different material ESG factors over the short term, medium term, and long term. In the case of Argentinean sovereign debt, governance issues such as political stability and institutional strength are key long-term drivers of returns, whereas in the short term, extreme weather, such as the drought in 2017–2018, had significant influence on agricultural production and trade balance. (For a more in-depth analysis of ESG integration and sovereign debt, read A practical guide to ESG integration in sovereign debt).

ESG factors also can move from the long term to the short term and vice versa. Rob Wilson, research analyst at MFS Investment Management, explains that in the past, he often has been amazed at how quickly some of these E&S factors became investment relevant:

”We did some research on income inequality back in 2014. A couple of the key sector takeaways related to drug pricing and H1B visa risks in the United States. My thesis in 2014 was that over the next ten years these ESG issues were likely to become important, but all of a sudden, within a year and a half, these topics were big news from both a political and a regulatory standpoint. They entered the social consciousness much more quickly than expected. Over the years, I’ve seen similar outcomes on tax, technology ethics, and other environmental and social topics.”

All of a suddent, ESG issues were big news from both a political and regulatory standpoint. They entered the social consciousness much more quickly than expected

Rob Wilson, MFS Investment Management

Masja Zandbergen-Albers, head of sustainability integration at Robeco, reveals that “the whole idea of doing your investment analysis with a long-term perspective is because you never know when the long-term factors turn into short-term factors and therefore you never know when ESG factors are going to hit—it can be tomorrow.”

You never know when the long-term factors turn into short-term factors and therefore you never know when ESG factors are going to hit—it can be tomorrow

Masja Zandbergen-Albers, Robeco

Falling holding periods

One possible consequence of ESG factors becoming more short term in nature is that more investors with short-term strategies will embrace ESG integration for alpha generation. As Wilson demonstrates:

”If you’re a high turnover or momentum-oriented fund, you may decide that you want to play the semiconductor cycle, so you’re probably going to go back to certain semi stocks multiple times in a three or five-year time period. That fact means you own that semiconductor stock for perhaps three or three and a half years out of five, even though you may buy and sell it several times. As a result, the probability that you’re going to be impacted by one of these ’long-term ESG issues’ during your ownership of the security is still actually relatively high, so I do believe that all investors need to be aware of ESG risks and opportunities.”

Another consequence is that while you may have a long-term investment horizon, in some incidences, you could have a shorter holding period than you anticipated. As Yeoh puts it, “This is the interesting thing about the time-frame horizon analysis period versus holding period. At a security level, all of a company’s value may have crystallised within three months. So, you might have been looking at it in a longer view horizon but only holding it for a short term period.”

This is the interesting thing about the time-frame horizon analysis period versus holding period. At a security level, all of a company’s value may have crystallised within three months. So, you might have been looking at it in a longer view horizon but only holding it for a short term period

Benjamin Yeoh, RBC Global Asset Management

Why does it matter?

This begs the question: why does it matter that ESG factors are not considered to be short-term factors? Investment horizons can stop investors from considering material ESG factors that can increase investment risk within a portfolio, especially those with a short investment horizon. Other investors are spending a lot of time identifying which ESG factors are material and predicting when they will be material—will it be in within one year’s time, two years’ time, or five years’ time?

Because the timing of ESG events is difficult to predict, these investors argue that ESG integration is invaluable for all investors, especially as ESG factors are considered to increasingly affect market prices in the short term and long term.

As Aaron Ziulkowski, CFA, investment analyst and manager, ESG integration at Boston Trust Walden, said, “Judgement around materiality of ESG issues is connected to investment time horizon. As long-term investors, ESG issues are important to our investment process and identifying high-quality companies.”

 

 

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