In This List

Carbon Risk Integration in Factor Portfolios

Bond Market Match-Up: U.S. Corporate vs. Muni Bonds

Corporate Carbon Disclosure in North America

Is Active Management Getting Harder?

Carbon Pricing: Discover Your Blind Spots on Risk and Opportunity

Carbon Risk Integration in Factor Portfolios

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Bill Hao

Director, Global Research & Design

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Aye Soe

Managing Director, Global Head of Product Management

INTRODUCTION

In the past, discussions on carbon risk would typically involve scientific arguments regarding climate change and whether existing evidence supported market participant action for carbon-awareness investing. In recent years, climate change policy and knowledge have progressed to the point where many large institutions across the globe have already begun to incorporate varying degrees of carbon risk integration into their investment process.

Concurrent to the low-carbon investing trend has been the adoption of factor-based asset allocation by institutional investors. Institutional investors who are implementing factor-based investing into their core equity allocation and who wish to align their entire investment process with lowcarbon initiatives may need a total portfolio management approach, in which metrics related to carbon risk are integrated with signals from traditional risk factors. As such, there is a clear need in the market for studies that examine the impact of carbon risk integration with traditional factor portfolios.

Therefore, the debate at this juncture centers more on how imminently carbon risk is priced and thus to what degree market participants should position their existing portfolios. As a starting point for carbon-awareness investing, knowing the carbon footprint of a given portfolio is required. However, carbon footprint measures only part of the carbon-pricing risk and is not forward looking1 in providing a complete estimate of carbon risk exposure.

For various reasons, including data availability and history, as well as the focus of the paper being to demonstrate portfolio implications of incorporating carbon-related metrics, our paper adopts a simpler approach by examining carbon risk through a carbon-efficiency lens.

In this paper, we argue that a pure, unconstrained, carbon-efficient portfolio outperforms a carbon-inefficient portfolio, as well as the underlying benchmark, on an absolute return basis, but underperforms on a riskadjusted basis due to the portfolio having higher volatility. Moreover, we discuss how the carbon-efficient portfolio exhibits unintended sector and factor biases. Using the correlation of carbon intensity with style factors, we demonstrate a stylized framework in which carbon-efficient portfolios (both unconstrained and sector relative) can be combined with traditional risk factors to lower carbon intensity while maintaining the target factor exposure.

Through this analysis, we merge two powerful trends that are shaping the investment industry, and we provide a framework that can be used by institutional investors who wish to be sustainability-driven while focusing on achieving risk/return profiles that are specified in their investment mandates. We show that carbon-efficient factor portfolios can be a meaningful part of the core equity strategic and tactical asset allocation process.

The framework we have provided in our paper is by no means exhaustive. There are numerous ways to achieve decarbonized factor portfolios, each with its own tradeoffs and unique characteristics. Hence, in subsequent papers, we intend to explore additional case studies and provide stylized examples through which advantages and disadvantages of each approach can be further understood.

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Bond Market Match-Up: U.S. Corporate vs. Muni Bonds

The U.S. corporate and municipal bond markets seemed to be neck and neck in terms of total return performance for the first three quarters of 2017. However, distinct characteristics of both markets that have played key roles in driving performance could cause performance to vary significantly going forward.

Let’s take a look at some of the potential performance drivers and differentiators.

Coupon cash flow: As of September month-end, investment-grade taxexempt municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index had an average coupon of 4.61% vs. the average coupon of 3.72% of the bonds in the S&P 500®/MarketAxess Investment Grade Corporate Bond Index.1 In a low-yield and low-expected-return environment, municipal bonds offer higher-interest-rate cash flow that is tax-exempt. Advantage: municipal bonds.

Yield: Investment-grade tax-exempt municipal bonds on average have yielded 2.03% vs. higher-yielding taxable investment-grade corporate bonds. However, looking at it from the perspective of taxable equivalent yield (TEY), municipal bonds have recently been at higher yields than their corporate bond equivalents.2 Please refer to table on next page. Advantage: municipal bonds.

Duration: Investment-grade corporate bonds from the companies of the S&P 500 are tracked in the S&P 500/MarketAxess Investment Grade Corporate Bond Index. Their average duration has been over 7.75 vs. an average of 4.8 for investmentgrade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index.3 In general, in a rising rate environment the lower duration favors municipal bonds. Advantage: municipal bonds.

Market size: U.S. corporate bonds that are index-eligible tend to be very large issues. The market size of the corporate bond market tracked in the S&P 500 Bond Index, a broad index, is over USD 4.5 trillion.4 The broad S&P Municipal Bond Index tracks over USD 1.77 trillion of the USD 3.8 trillion municipal bond market.5 The larger corporate bond market tends to be more liquid.

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Corporate Carbon Disclosure in North America

North American firms quantify supply chain risks, set science-based targets, and implement internal carbon pricing.

EXECUTIVE SUMMARY

Trucost, part of S&P Dow Jones Indices, assessed the trends in corporate disclosure of carbon emissions to see how companies are managing risks in three important areas: quantifying supply chain carbon emissions, setting meaningful emission reduction targets, and pricing carbon to understand the current and anticipated financial implications of impending regulatory and policy measures.  The headline findings include the following.

  • In 2017, North American businesses continued to expand their carbon reporting to all-time highs. However, this reporting varied greatly in terms of depth and breadth.
  • Many corporations, particularly in the health care, financial services, and information technology sectors, do not fully track the carbon sources that are most material to their business activities.
  • North American companies surpass global companies in quantifying supply chain carbon emissions.
  • Companies in North America are increasingly setting science-based targets that will cut emissions in line with international efforts to limit global warming to 2°C.
  • More than one-third of North American companies have set an internal price on carbon to help understand the risks and opportunities of the transition to a low-carbon economy.

INTRODUCTION 

Trucost analyzed environmental data submitted by companies to the CDP annual climate change questionnaire. Trucost compared data for 2017 with previous years to identify trends in carbon management and reporting, focusing on companies in North America. The analysis covers emissions from company operations and use of electricity (scopes 1 and 2, respectively), as well as value chain emissions (scope 3) as classified in the Greenhouse Gas (GHG) Protocol.1

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Is Active Management Getting Harder?

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

The data are clear. Our year-end 2016 SPIVA® U.S. Scorecard, e.g., showed that 66% of large-cap mutual funds underperformed the S&P 500 in 2016.1 Results were even worse for mid- and small-cap managers. Nor were 2016 results unusual—in the 15 years we’ve produced SPIVA, active managers beat the S&P 500 only three times. Moreover, when active success has occurred, it has tended not to persist. Our Persistence Scorecards demonstrate that an investor has a better chance of flipping a coin and getting four heads in a row than he does of identifying a fund manager who will be above average four years in a row.2

Successful active management is obviously difficult, and there are two reasons to suspect that it may become even harder.

First, there is no natural source of outperformance (or, in technical jargon, “alpha”). One investor can earn a positive alpha only if some other investor earns a negative alpha. Successful (or lucky) active managers, in aggregate, can only produce positive alpha if less successful (or unlucky) managers endure negative alpha, and the aggregate value of the winners’ gains is exactly offset by the losers’ underperformance. Since trying to earn alpha costs more than passive management, whether the quest is successful or not, it’s not surprising that most active equity managers typically underperform a passive benchmark; nor is it surprising that passive management has consistently gained market share relative to active management.

But what happens when passive management gains share? Where do the passive assets come from? If some active managers are more skillful than others, and their skill is manifested in outperformance, then presumably it is the least skillful active managers who lose the most assets. In that case, the existence of a passive alternative raises the quality of the surviving active managers, thus contributing to market efficiency.3 By reducing the number of potentially underperforming active managers, indexing makes it harder for those who remain.

Second, a new generation of indexlinked products makes it possible to indicize strategies that were formerly the exclusive preserve of active managers. Smart beta or factor indices provide exposure to a wide range of attributes which investors may find attractive. Consider, e.g., an active manager who historically has tilted away from his or her capweighted benchmark in a systematic way (perhaps by emphasizing value, or small size, or low volatility). The manager’s clients have had no way of disentangling how much performance is attributable to factor tilts and how much is attributable to stock selection beyond the factor. Now, factor indices make it possible for the client to access the factor, without paying for a manager’s stock selection, and to do so transparently and at low cost. Thus smart beta may also make life more challenging for active managers.

SPIVA tells us that most active managers underperform most of the time; the growth of both cap-weighted and factor-based passive investing suggests that the future of active management is likely to be just as grim as its recent past. Of course, what is true across the population of active managers does not mean that individual managers cannot be exceptions. Indeed, managers like Warren Buffett and Peter Lynch are famous because their performance was exceptional. If most active managers could outperform consistently, we wouldn’t celebrate the few who do.

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Carbon Pricing: Discover Your Blind Spots on Risk and Opportunity

EXECUTIVE SUMMARY

  • Carbon pricing risk from a growing array of new policies and taxes spurred by the Paris Agreement could lead to significant losses on a company’s financial statement.
  • Carbon pricing risk could vary substantially among companies operating in the same business sectors.
  • The financial risk from carbon pricing schemes depends on a company’s carbon efficiency, location of operations, business model, and the market conditions of the sector.
  • Company business models and broader market conditions will also dictate whether companies are able to absorb the increased costs or pass them on to their customers.
  • At present, many companies measure their carbon footprint, which is an essential first step in understanding carbon efficiency of past operations, but it has a blind spot in regard to future carbon pricing risk exposure.
  • Because a significant share of carbon pricing risk could come from supply chain activities and energy-intensive products, it is essential for companies to account for carbon risk beyond their direct operations.
  • Meaningful data disclosure by companies on future carbon risk, as recommended by the Task Force on Climate-Related Financial Disclosures, will help inform the decision making of investors and accelerate mainstream green finance.
  • THE GROWING RISKS FROM CARBON PRICING

    Following commitments under the Paris Agreement to limit global warming to 2 degrees Celsius, governments are increasingly imposing a price on carbon, shifting the cost of greenhouse gas (GHG) emissions from society to the source of pollution. In 2013, Trucost estimated that the cost of GHG emissions from business activities that were linked to reduced crop yields, flooding, disease, acidification of oceans, and biodiversity loss was USD 2.7 trillion.1 Pricing carbon provides an incentive to reduce GHG emissions and invest in low-carbon technologies. While current carbon prices average around USD 40/tCO2, 2 they are expected to increase in the near future, reaching up to USD 120/tCO2 by 2030 in Organisation for Economic Co-operation and Development (OECD) countries under a 2 degrees Celsius-aligned scenario. 3.

    The growing carbon price could affect companies directly with regulatory costs imposed on their operations through energy and fuel price increases, or indirectly through costs passed on by suppliers. These costs may be borne by companies or passed on to consumers in the form of higher prices. Rising prices, along with the increased cost of using carbonintensive products such as motor vehicles, may depress consumer demand.

    Understanding carbon pricing risk exposure is therefore essential to managing business risk and building resilience to intensifying global climate policies.

    At present, many companies measure their carbon footprint—a measure of carbon intensity and efficiency, and a vital first step in understanding exposure. However, across the global network of carbon policies, carbon pricing risk will vary over time according to the type of business activity and location. Relying on the carbon footprint as the only indicator of carbon pricing risk exposure could create a blind spot regarding the financial implications of carbon policies for companies and their investors. Companies should look at how carbon prices affect the cost of global value chain impacts, as well as the net impact on profitability across different scenarios and time horizons. This type of financial scenario analysis will be important in responding to climate risk disclosure initiatives, such as the Task Force on Climate-related Financial Disclosures (TCFD), which aims to help investors, lenders, and insurance underwriters appropriately assess and price climate-related risks and opportunities.

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