A stepwise path to fossil-free strategy outperformance

New report highlights potential for benchmark-beating returns by going beyond 'naïve' fossil-fuel divestment

A stepwise path to fossil-free strategy outperformance

Given the science that has been established around carbon emissions and climate change, there’s hardly any need to convince responsible investors that fossil fuels are a major contributor to the problem. The potential sticking point, particularly for those considering a divestment strategy, is whether they could exclude companies with fossil-fuel exposure without hurting their portfolios’ performance – and the answer, according to one investment firm, is yes.

“That’s the big question that a lot of our clients have,” said Mike Thiessen, director for Sustainable Investments at Genus Capital. “They’ve already made the values decision to divest, or at least do something to build climate action in the world. But then they always ask ‘How will this affect my overall performance? Can I save for retirement? Can I save for whatever I might have planned in the future?”

Genus hopes to allay those concerns with a recently published report. It highlighted how over the seven-year period ending July 31, 2020, the firm’s Fossil Free CanGlobe Equity Fund has outperformed its benchmark, which includes a 25%-75% blend of Canadian and global stocks. During that time, the fund recorded an annualized return of 12.8%, versus the benchmark’s return of 10.95%.

“We’ve always said that we don’t need fossil fuels in our portfolio to make good returns, and our live performance has been showing that,” Thiessen said.

The report’s findings go even further with a long-term fossil-free backtest. Starting with an array of benchmarks covering Canadian, U.S., international, and global stocks, Genus simulated two different approaches to fossil-fuel divestment: a “naïve” approach that simply ejected the Energy, Utilities, and Transportation sectors from the benchmark, then reweighted the remaining stocks proportionately; and an “optimized” approach, which takes the added step of performing a quarterly optimization to minimize the portfolio’s tracking error versus the benchmark.

The test found that over the period from August 31, 1998 to July 31, 2020, the naïve approach for Canadian, U.S., and international stocks would have resulted in underperforming portfolios. But with the optimized fossil-free approach, the resulting portfolios actually exceed the returns of their corresponding benchmarks.

Genus’s own investing process, Thiessen said, goes beyond the optimized fossil-free approach. From there, the firm applies a battery of ESG screens to flush out companies and sectors that run against its clients’ values. The list of undesirables includes controversial industries like tobacco, weapons, and gambling, as well as companies that score in the bottom 5% in terms of Environmental, Social, and Governance issues. High-carbon-intensity companies, which emit an unsettlingly high volume of carbon emissions per million in sales, are also filtered out.

“It also helps to mitigate potential risks that come with controversial industries,” he said, pointing to concerns like litigation, regulatory scrutiny, punitive taxes, and cultural backlash that could mount against companies with questionable operations or business models.

After the screens, the firm uses proprietary alpha models, which rate companies based on their financial potential for the coming year. It puts companies through a quantitative stock-selection process, looking at factors such as value, growth, and momentum, as well as earnings expectations and a whole host of other measures.

“When you put them all together, then our backtests show that resulting portfolio performance can be quite a lot better than the index,” Thiessen said.

In a short-term fossil-free backtest, the report looked at how its investing process would fare against a benchmark with 35% exposure to TSX-listed Canadian stocks and 65% to the MSCI World Index. It found that over the period from May 31, 2011 to July 31, 2020, the overall process of fossil-fuel divestment, optimization, ESG and carbon screening, and using alpha models would have outperformed the benchmark by 6.08%.

Thiessen acknowledged that the outperformance during that period was partly due to oil price drops that dragged down the more energy-exposed benchmark. But since the oil industry frequently gets caught in the crossfire during geopolitical crises, he maintained that investors would be better served by portfolios whose performance is not held captive by what oil prices are doing.

The report also highlighted how impact investment, as represented by the Genus Fossil Free High Impact Equity Fund, emerged as a winning strategy during the recent COVID-19-driven downturn in financial markets. Over the period from December 31, 2019 to July 31, 2020, it logged a cumulative return of 9.98%, compared to 2.35% for its benchmark MSCI World Index.

“The fund invests in a lot of solutions to the world’s biggest problems, which we’ve certainly needed this year,” Thiessen said. Aside from healthcare, the fund has assets in technology related to renewable energy and energy efficiency, as well as some stakes in companies that advance education.

“The bigger overweights throughout this year have been to healthcare and technology, which has gained as people move to more cloud-based systems,” he said, noting the energy-efficiency gains that businesses can reap from working on the cloud at scale. “A lot of people have also been looking at renewable energy this year not just because of the volatility in oil, but also in anticipation of a Biden win this election.”

While Genus doesn’t expect its impact fund to see that type of outperformance forever, it is expected to perform well as it creates a natural hedge against crises. It also addresses the transition risk faced by whole industries as countries around the world rush to become carbon-neutral by 2050.

Of course, taking a divestment approach to fossil fuel firms might sound regressive on its face to ESG investors, especially given the broad shift from negative screening to active engagement. But Thiessen argues that investors can send the strongest signal to those companies by walking away.

“There’s really not any incentive for energy companies to change,” he said. “They make money off selling oil and gas, so they’re not going to switch suddenly to solar or wind. Some may say on their websites and marketing materials that they’re a green company because they’ve invested in those, but you’ll find it’s just a fraction of a percent of their overall revenue.”

He acknowledged that investing in a company and engaging with them can be a source of large change. But by divesting, he said investors can strongly express their convictions on a company’s negative impact on the planet by raising its cost of capital. More importantly, a large foundation or institution that divests itself from a company can influence other investors, sparking a powerful push for the company to change its ways.

“We do a lot of engagement with companies that we invest in, but these are companies whose general business models we believe in,” Thiessen said. “We’re just encouraging them to be even better by going paperless or treating employees better. Using engagement to make a company give up the business model that’s worked for it for so long … I just can’t see that working.”


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