Long Story Short: Sustainability and Systematic Investing

 

How can sustainability be integrated into a modern, multi-asset portfolio? In this bonus episode of Long Story Short, Otto van Hemert, Harry Moore and Ed Hoyle take a look at how sustainability can be integrated across commodities, government bonds and more.

Further reading:

https://www.man.com/maninstitute/investing-responsibly-commodities
https://www.man.com/maninstitute/path-less-travelled-green-bonds
https://www.man.com/maninstitute/path-less-travelled-investing-responsibly-in-government-bonds
https://www.man.com/maninstitute/best-strategies-for-inflationary-times

Recording date: February 2024

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Harry Moore:

Hi everyone. Thanks very much for joining us today on a special edition of Man Group's Long Story Short podcast, and I said I'm delighted to have two great guests. So who are they? The two partners from AHL, Otto Van Hemert and Ed Hoyle. Both of them cut their teeth in academia before moving over to systematic investing. So let's jump into today's topic, which is integrating sustainability into multi-asset portfolios. Now both of you here is this naturally falling into Man AHL's wheelhouse, so quant derivatives, these kind of challenges that make it potentially sound like this might be something a bit difficult for a firm like Man AHL. What do you think on that, Otto?

Otto Van Hemert:

I do think it's a natural fit for Man Group and AHL as well. First of all, it starts with thinking deeply why it all matters. Why does it matter if you invest in a security that may be ESG aligned or not, ESG aligned? How does it impact real outcomes as in carbon emissions or social justice or other things that fall under the common denominator of ESG? So thinking through the premises behind a certain concept is something we do a lot. Second of all, it evolves a lot of data, data cleaning, interpreting data, scrubbing data, and we have an entire data science team that focuses on that. Third of all, we have a responsible investing unit within the firm that helps out a lot with the latest thoughts from the RI and ESG community. And finally I would say, and you mentioned this before, ESG or responsible investing is not just something for stocks, it covers other asset classes as well logically, and we are experienced trading a broad range of macro and micro asset classes. And therefore, yeah, for those reasons, I do think it's a topic that's very natural to us.

Ed Hoyle:

But I think our attitude to this has changed. So when I joined AHL, which was seven years ago, we were asked by investors about ESG and what we were doing. And much of what we do is systematic macro, trading futures and forwards and those sorts of things. And we basically said, there's not a lot we can do, but we kept getting the questions and then we kept thinking about it and the more we thought about it, we thought, well, maybe there is something we can do. But there weren't templates out there, there weren't people who were really doing this sort of thing from a multi-asset point of view. And so we decided just to have a go ourselves and think about how we think a sensible approach is and then put that into practise.

Harry Moore:

I guess that's why you've called the series the path less travelled than Ed, taking it through with a lot of difficult asset classes that haven't historically had as much attention. I'd like to pick apart something that you did touch on there, which was basically this is difficult in systematic macro and certainly from my perspective what I've seen is that most work on sustainability has been in equities. That seems to be pretty well-developed. Why do you think it's taken so long for it to catch up in, for example, another humongous asset class, which is government bonds? It seems to be lagging somewhat behind.

Ed Hoyle:

Well, I think the equity market first of all is enormous and it's also where people go to to get long-term growth and the type of analysis that you need to do particularly and responsible investing in the equity market is very much bottom up. And the approach of doing bottom up analysis and comparing one company to another based on firm characteristics has got a long history in the equity market. It goes back at least to the 1930s with Graham and Dodd and value investing and all that. The other thing is when you're a stock owner, you own part of the company and that ownership gives you the right and the opportunity to have some influence on how that firm is run as well. So that's also a natural step towards responsible investment.

When you move away from the stock market, you have to translate this thinking to other asset classes and sometimes it doesn't work so neatly. You don't have such a straightforward comparison of the responsible investing characteristics of gold versus livestock for example, in commodities or in government bonds between one. So in government bonds, people compare one region to another based on their economic fundamentals like economic activity or inflation. And when looking at government policy, they're thinking about, well what are they doing to stimulate growth rather than what's the government doing to improve people's welfare or reduce inequality or what have you.

Harry Moore:

Thanks Ed. And you Otto, what's your view particularly I'd say an asset class like commodities for example? That's been historically very difficult to integrate any sustainability into. If you've got a view on why it's taken so long and do you think now that we do have developed frameworks or is it still in its infancy?

Otto Van Hemert:

Yeah, I would say the attitude towards commodities has changed a bit over time and perhaps partly because of people like us and others having written about it. The initial attitude was perhaps one where it was noted that commodities typically are bad to produce. It's invariably there are some CO2 emissions when you produce a commodity, whether it's a metal or energies or agricultural contracts. What's missing though is that it can also have a utilisation that's very favourable. Some metals you need in the electrification of the world or you need agriculturals to eat, you need to heat your house and build a roof on top of your head. So there's a need for commodities and some of them are more essential than others. So you need to look at both production and the utilisation side of things. You need to weigh the two against each other and then a clear picture emerges. At least that's our view.

So there's a couple of examples you can give, but let's start with gold versus silver. Both precious metals, both quite correlated, so similar in terms of their return dynamics, but gold is more harmful to produce, to mine than silver and it's way less useful in its industrial uses. Silver on the other hand is very useful. It's the most conductive metal out there ahead of copper. That's more typically used because it's a bit cheaper and ahead of gold, it's silver that's the most conductive used in solar panels and other applications. So there's a real distinction between silver and gold, silver being the one that is useful in the green revolution if you like. And gold is not.

So trading commodities can be really well-informed in terms of the net benefit. You have utilisation for production, you can take this to other types of commodities as well. You can compare different oil contracts where Brent is often claimed to be less polluting in its origins compared to WTI, which uses a lot of fracking technologies. It's often said that grains are a better way to feed ourselves than livestock and meats because livestock and meats are a more roundabout way of producing a nutritional unit compared to just producing the grain. So there's a lot of sensible analysis you can do. There's a lot of useful data to be gathered on commodities and that can inform an ESG oriented investment approach in commodities.

Harry Moore:

Thanks very much, Otto. There are a lot of points there, but it sounds like some key topics were focusing on the production and historically people have been very much focused just on the production side and as you mentioned, all commodities are bad to produce, but there's this other side to the coin which is the utilisation and some are good, potentially have benefits. In green revolution, you mentioned silver for example. So you've come up with a framework here that can compare and contrast commodities. Maybe I'll throw that over to Ed. As an investor, as a systematic investor, how can you then take those comparisons and do something useful for investors or incorporate that into your investment process?

Ed Hoyle:

Yeah, so I think the role for commodities within the portfolio is, there's a couple of really important things that it offers. One of them is diversification. We like diversification because it's a good way of reducing the overall risk you might have in the portfolio or in fact it's a way we often use it to build a more diversified portfolio that allows you to take more exposure, potentially getting a high return but without having to take extra risks there. The other thing of course is that commodities being real assets tend to perform well during inflationary times. And in inflationary environments as we've seen recently, can be very damaging for both stocks and bonds simultaneously.

So if you're building a multi-asset portfolio, incorporating liquid inflation sensitive assets is always going to be a bonus. So when we're actually building our portfolio, when we're thinking of comparing the viability or the responsible investing credentials of one commodity for another, ultimately we're still comparing two things that are real assets. We're comparing things that we think would hold value in real terms in times of inflation. And we actually have some academic work that was recently published that Otto was a contributor to that documents all this as well.

Harry Moore:

So what paper was that Otto wrote that maybe our listeners at home might want to go and read?

Otto Van Hemert:

It's The Best Strategies for Inflationary Times and thanks for that…

Ed Hoyle:

Any time!

Otto Van Hemert:

There's one other thing to add here and that is the securities we ultimately tend to trade are the futures on commodities. Futures have existed for a long time. Mid 19th century, the sea boat was established and the first grain contracts were established. Already well before that rice futures were traded in Osaka, Japan. So there's a long history and futures markets for commodities have a particular goal and that is to facilitate risk sharing between producers and consumers of commodities and potentially speculators that want to help make liquidity in the market as well. And it's good to bear that in mind because then what is the role of trading a commodity future? You help facilitate risk sharing. That holds irrespective of whether you're long or short. So in essence, our view is that if a commodity future is deemed a ESG aligned commodity future, we are happy to participate in the market long or short. And that contributes to a well-functioning market. And if we deem a commodity future not as well aligned with ESG objectives, then we don't trade it, not long nor short. We don't want to help make liquidity in that particular market.

Harry Moore:

So by participating, you're increasing the capacity for risk sharing in that commodity?

Otto Van Hemert:

That's right.

Harry Moore:

So here for the examples, given you want to participate in silver. Potentially you wouldn't trade gold. Back to you Ed, in terms of portfolio impacts. If I take this, the whole hog and I incorporate this type of information, what is my commodity portfolio going to look like?

Ed Hoyle:

If you do want to compare then metals and silver, something we looked at in a paper we wrote together, Harry, what you find in the long run is that looking at metals alone, so industrial metals and silver versus a broader commodity index, the returns in the long run looked higher with more volatility, which you might expect because it's a bit less diversified. But the two were reasonably highly correlated. And I think the important point is, as I mentioned before, it's about them being real assets. Still these metals are real assets. They have a use, they're easy to store as well, which also means that you have less issues around technical things like storage.

Harry Moore:

So if you're an investor and you're looking to do good with your commodity allocation, potentially you're going to end up with more metals in there. Agriculturals, as you mentioned, potentially you'd favour grains, but there's other considerations. Now I wanted to talk about one other asset. It's sometimes classified as a commodity. We know that certain investors do trade them and that is EUAs or European allowances. What are your thoughts on incorporating putting a price on carbon into a portfolio?

Ed Hoyle:

So yeah, carbon credits are interesting. That they are linked to, at least the price of them is closely linked to real activity because where we would expect the price of carbon emissions to go up, we would expect there to be a lot of action in the real economy, which means when you think about them from an inflation sensitivity point of view, when compared them to commodities, which is how we typically do it, there is that link there. There is a link to the real economy because manufacturing and industrial production is really going to be carbon intensive and that's why you need them. So they are interesting from that point of view. And then they also have two benefits from an ESG perspective. There's the disincentive to pollute particularly where people are forced to pay for carbon and there's also, they promote the transition to greener technologies as well. So can we do things in a greener way and by making carbon emissions expensive, that's a way of forcing people into that. So I think they're definitely interesting.

Harry Moore:

Now I'd like to pivot to government bonds. We've done a lot of discussion on commodities. Governments are another very large allocation for a lot of our listeners, a lot of people at home again thinking, well what can I do on sustainability in governments? You hold these assets for stable returns, diversification. Governments make decisions about everything we do. Otto, potentially this is a good one for you to take. What do you think of incorporating sustainability into government bonds?

Otto Van Hemert:

As you mentioned, governments are important. They can make rules, they can make laws, they have armies, so they have an important role to play with any change including a change to a cleaner world, a more greener world. Governments issue government bonds, their way of financing some of their activities, and therefore you can choose to invest or not invest in a government bond and therefore impact the cost of financing for a government. When doing that, it's important to compare apples to apples. Not any two countries can be compared straight away. You need to factor in, they may be in a different phase of their development cycle. Here is a concept called the environmental Kuznets curve that says that countries go through kind of three phases. The pre-industrial phase when they're not that much emitting greenhouse gases, wealth levels are still fairly low, then they go through their industrial revolution, emissions are quite high, incomes are rising for people in the country and then they're in their post-industrial phase when emissions go down again and wealth is further accumulated.

Now it's unfair to compare a country that already has gone through its industrial revolution and is now in that post-industrial phase to compare such a country to a pre-industrial revolution or inside the industrial revolution country. They, in some ways, the post-industrial revolution country already had its chance to pollute. Maybe you've done that 100 years ago and now we are in a different place. So really what the thinking is, is that you should compare apples to apples. You should compare countries in a similar phase of their development cycle and then make a judgement if they look good or less good in terms of ESG factors or responsible investing factors you may want to consider.

Ed Hoyle:

Well Otto, you said it was unfair to compare them. I'd say it's hypocritical to compare them even, but I think there's a responsibility for developed economies who have gone through that industrial revolution and who have come to and are lower emitters and are doing less environmental damage to share their technology with those who are going through similar things now. So rather than say don't do this, rather than say, can we help you do this in a green and a more sustainable way?

Harry Moore:

Yeah, I think that's a really good point. So we need data to look at which countries are doing that and which ones are shunning their responsibilities. Would you mind giving some real world examples of the type of data you might look at to select a country that is more aligned in your opinion? Maybe give some examples both in the developed and emerging markets, especially if we're using different frameworks to select them.

Ed Hoyle:

Well certainly one of the bits of data we use is looking at the CO2 emissions per capita, and this is information, for example, that the World Bank make available. And then you can see countries like the United States a particularly intensive emitters of CO2 versus I think typically the lower polluting nations or Northern European ones. So that's one example of the data we can use.

Harry Moore:

And if you incorporate that type of data into your portfolio straight away, I'm seeing that you said the US is a high emitter potentially. They're going to get a lower weight in your allocation. Is this right?

Ed Hoyle:

Yeah, so if you actually look at government bonds, two of the largest issuers of government bonds are the US government and the Japanese government. But I think when looking at the criteria that we typically look at, they would get underweights versus, as I said, some Northern European countries, which I think look particularly good.

Harry Moore:

So long-term as an investor, does that give you a different return profile? You've got rid of two of the largest bonds there. Am I giving up anything in terms of diversification, long-term returns?

Ed Hoyle:

Perhaps a small amount. There are always periods where one region's going to outperform another, whether that's the stock market or the bond market or what have you. But I don't really see when comparing highly developed nations that one ex ante is going to do particularly well versus another. So for me, maybe a small loss of diversification, but I don't really think, at least historically in our analysis, we've not really seen any meaningful return differences and going forward, I wouldn't necessarily expect some, but there will be periods where obviously one region will do better than another.

Harry Moore:

And Otto, you briefly mentioned this, so by deciding that you're not going to invest in a country or invest in a different one, your primary impact is via the cost of capital. Would you agree with that?

Otto Van Hemert:

Yeah, I believe that's the main channel for impacting real outcomes. In the end, you may encourage governments ultimately to change their ways by changing their cost of capital. That's the classic argument at least. I think there is a secondary channel and that is that a government may care about its broader reputation as well and if it's generally considered to be good or not so good on the ESG front, that may have other impacts on it as well. So there's a softer argument why governments may care about how they're looked at from an ESG point of view.

Harry Moore:

So it's soft power Olympics. Governments throwing money after the [inaudible 00:21:43] white elephant projects. I think there was a really great example back in 2021 on doing business in countries actually fighting each other to try and get their ranking improved, which actually doesn't help anything other than their ranking. So you've got these kind of, certainly these perception and sentiment effects. Okay, so we've spoken about commodities, we've spoken about government bonds. Now if we pivot to discuss not just the asset classes, but incorporating these types of principles into an investment strategy. Now of course here at Man AHL, we run a lot of AUM in trend following. Now historically trend following has been one of those strategies where people have said, well, you can't integrate sustainability into that. There's too many problems. There's long and short, you're trading mostly derivatives, you've got a fairly short holding period. What do you think about that, Otto?

Otto Van Hemert:

It takes a lot of thought and in particular it takes thinking about why does investing in the security impact real outcomes? And when you trend follow a broad range of macro markets, you do have to distinguish between different types of markets. For example, equity indices or government bonds, there are markets where we think the cost of capital argument holds. So you would want to be long ESG friendly securities in those categories and less ESG friendly securities to influence that cost of capital. Very different are the commodity markets, for example, where we believe it's risk sharing primarily. And you want to participate, long or short in the ESG friendly commodity futures and not participate at all either neither long, neither short in the less ESG friendly commodity futures. That leaves one asset class that we haven't really touched upon and that is currencies or FX that are typically traded in trend falling funds as well. We believe there too, it's a re-sharing asset class. So you want to participate in the currency of countries that you deem ESG aligned and not participate in countries that are not as ESG aligned.

Harry Moore:

And I assume you would use those frameworks that you and Ed have discussed so far to select those assets throughout the portfolio, is that correct?

Otto Van Hemert:

That's right. You use your data, your knowledge to produce ESG scores, which in the case of equity and assessing government bonds are used to go long the good ones and short the bad ones. And in case of commodity futures and currencies, you just go long and short. You provide re-sharing services for the ones that have a good ESG score.

Harry Moore:

So another angle in trend following is that it's a very cash efficient strategy. If you as an investor put your capital to work, a lot of it will be sitting in cash. Otto, are you able to take some of those concepts that you and Ed have discussed and apply it to the cash management section?

Otto Van Hemert:

Yes, absolutely. So you're sitting on mostly cash because as you mentioned, futures just need a posting of margin to trade. Often the cash is held in US short-dated debt, T-bills, but the US doesn't always rank the highest among the different countries in terms of ESG. You can choose to hold the cash in a different currency of a different country where in particular the Northern European countries are ranked well in terms of their ESG score. So you can hold the short data in those countries.

Harry Moore:

So we've discussed the single asset classes, we've looked at trend following, which is long and short. Now spinning back to you Ed and maybe back to a long only type investment, could you briefly touch on performance and integrating these types of concepts? Where do you see differences in performance? What can a client expect when you integrate these principles?

Ed Hoyle:

Yeah. So when we come to multi-asset investment, it becomes quite interesting. I mean for a start, we talked before about differences in investing in government bonds and how the returns might vary to different regions. Now in a multi-asset portfolio, why you really want your bonds is to be a hedge against your equities in times of growth shocks. And there, the regional differences are much less important than owning the bonds as well as your stocks.

When it comes to building a responsible long only portfolio, one of the things you should always be aware of that adding more and more constraints to a portfolio is never going to improve your opportunity set. It's always going to make it smaller or leave it unchanged. And however, so you might take that to mean that expected returns will fall by building a constrained portfolio using ESG constraints for example. But actually as we've done more and more thinking, we've also increased our opportunity set by expanding into new asset classes, ones that we hadn't considered before. And in particular here I'm thinking about bonds, government bonds, corporate bonds, whereas before we were just focusing on our futures before we really took responsible investing seriously. So on the one hand, adding the constraint is potentially going to reduce your long run returns. At the same time we are opening new doors and we are improving capabilities in areas where we really haven't invested before. So in other areas we're able to increase our opportunity step, which will then be boosting things, improving our diversification and our long run performance. We hope.

Harry Moore:

Excellent. So that's quite an interesting topic there, which is potentially opening new doors. Are there other sources of alpha? I know Otto, this is something that you've looked at in the past, is does sustainability equal alpha or as an investor, do you have to be clear about what your goals and outcomes you're aiming for are with integrating sustainability?

Otto Van Hemert:

Yeah, so I think there's historically been a lot of confusion around ESG alpha as some people called it and ESG as a concept to insert because you believe there's an ESG risk factor or there's an ESG preference. I agree with that. It's not necessarily so that ESG is an alpha source, it is a set of constraints you ultimately put on top of an investment problem. It doesn't have to be a very binding constraint and there are ways to alleviate most of the impact, but it is ultimately, it's a set of constraints one imposes. So I think from that point of view, you need to be realistic about what it is. I do think we've come a long way in a couple of other directions and that is first of all, there's much more thinking now about why investing or not investing in a security even impacts real outcomes.

We've touched upon it several times in this podcast and we discussed our way of thinking around it with cost of capital securities and risk sharing type securities. But I think it's important to recognise those differences and be precise about it. I think another way we've made a lot of progress is on the data front. How do we even decide if a particular security is aligned or not so aligned with ESG? One thing to highlight there for example, is that historically a lot of thinking was done in terms of scope one and scope two emissions, which are the emissions a company does in its direct operations of business. But really scope three, the impact companies have, for example, because of their goods they sold have a certain impact are much more important. For example, a electricity car manufacturer may have very high scope one and scope two emissions, but then if you stop there, you ignore the fact that the electric cars they produce are actually very energy efficient and good for the environment.

But that all is captured under scope three. That originally was ignored a lot, but nowadays is included. And the third one, also a common theme in this podcast is that it really is not just stocks or corporate bonds, it's across asset classes that we should care. So to your question about how do people view ESG, how does it impact alpha or risk sharing or other concepts, to me it's really about the progress we made in terms of what is the channel through which we influence outcomes, what data do we have, how do we make the data better, and how can we apply this across the different asset classes?

Harry Moore:

Thanks very much, Otto. Well thanks everyone for taking the time to listen today. We've actually run out of time here with Ed and Otto. It's been an absolute pleasure to have you both. As a reminder, we've been all over the place since sustainable investing, covering government bonds, commodities. We even dipped our toe a little bit into trend following. Now, for listeners from today, if you do want more insights, please head over to Man Institute. Links are in the notes. As I said, a pleasure to have you both. Thanks for listening and we'll be back again soon.

Ed Hoyle:

Thanks Harry.

Otto Van Hemert:

Thanks for having us.