Volatility is the traditional measure of risk, but environmental, social, and governance principles can help identify risks that may not reveal themselves in the volatility numbers — and lead to a broader assessment of portfolio risk.
With that, investors can ask, “Am I really happy to take on that risk, or do I need to dial back because that can lead to more volatility in the plan, more volatility in the future, and ultimately losing the investment game because I’m losing capital? Because that’s what’s really important in risk management,” says Michael O’Brien, senior analyst and portfolio manager, Schroder Investment Management.
Governance is a crucial risk. On a quantitative level, for example, Turkey seems to be cheap.
“Well, what about the other risks that could be explaining some of that cheapness?” he asks. “It’s got governance risk. It’s got very poor shareholder rights. Economic freedoms are declining. It’s got very poor backing of that currency. It’s got debt issues. The growth prospects have really been pushed along via debt-funded growth. There are a lot of risks building up in that country.”
Not every risk matters all the time.
“Different countries will have exposure to different risks at different points in time,” he says. “And Mr. Market may decide that one of these risks is more important today or tomorrow, and volatility will ensue.”
Thus, while Turkey’s currency may signal underlying issues, Norway, which also has a volatile currency because of its reliance on oil, could still be a good buy. It scores quite differently on governance measures.
That’s a top-down approach. ESG criteria can also be used to evaluate stocks from the bottom up — and improve performance. “You can think of it in multiple ways, whether through exclusions as a kind of brute force way of excluding everything, or through integration by thinking about how you can use ESG to improve your potential outcome for your investors,” O’Brien explains.
“An example is a South African miner. South African miners have complicated labour practices issues. I don’t want to have that risk, so I just exclude it. But maybe a more active and engaged approach would be to engage these companies. Let’s talk to these companies and think about how you can get a little bit of outcome that is making your capital work harder and, ultimately, making a better outcome for everybody.”