waterVaR: A Smart Beta for Portfolio Construction

waterVaR: A Smart Beta for Portfolio Construction

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The risk impact of water on businesses is increasingly diffusing in investment circles, mainly though ESG indexing, but also via new offerings in the bond market, ETFs and water-driven portfolio designs.  The recent emergence of waterVaR and waterBeta indicators for companies and industry sectors has provided investors with financial risk data on how water impacts stock volatility.  In turn, waterVaR becomes a market signal for water risk exposures.  The asset risk component of waterBeta is illustrated in the figure (see earlier blogs on the description of waterVaR and waterBeta).

GRAPH02

Water risk = financial risk = stock volatility risk = portfolio active risk. The waterVaR and waterBeta factors inform alternative portfolio construction strategies, and could be construed as smart beta’s aimed at risk management.

What are smart beta’s?   

Smart beta is a rather elusive term in finance. It is also sometimes known as advanced beta, alternative beta or strategy indices.  It can be understood rules-based investing that does not use the conventional market capitalization weights that have been criticized for delivering sub-optimal returns.  Interest in smart beta indices has been fueled by the global financial crisis of 2007-08 which prompted many investors to become more focused on controlling risks than only on maximizing returns.

These strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes based on measures such as stock volatility or dividends, sales or cash flow.  Smart beta is more passive than active. Once the investment criteria are chosen, the strategy passively follows the rules that have been set, like investment in low-volatility stocks that are part of the S.&P. 500.  Smart beta is still an investing niche, despite all the attention it has garnered. Morningstar has estimated that at the end of last year $291 bn. of investments was in smart beta strategies.

So how are water risk and smart beta’s connected?

Let’s start with the physical side of water risk.   Data from NGOs and corporate disclosures indicate impact of water on revenue, COGS, margins and, potentially, asset depreciation.  The challenge with these data is their sparse availability, and poor time resolution of costs and impacts.  The waterVaR metric, on the other hand, captures stock volatility risk that is related to operational and asset-specific risk impacts for businesses, and is dynamic.   The premise of a smart beta is that the factor used for portfolio construction is objective, and based on independently verifiable financial data that are correlated to stock performance.

The figure exemplifies waterVaR data (yellow) for steel companies, and compares them to the market capitalization (blue) of the respective firms.   In many cases it is clear that the highest market cap does not correlate to the highest waterVaR.  The highest waterVaRs are financially material, representing up to 17% of stock volatility.   In this hypothetical scenario, if portfolio managers wanted to control volatility risk, with steel companies in their portfolios, a waterVaR-based smart beta may be feasible if the returns of this portfolio are above-market.

Steel-market-v-waterVaR-700x286

Recent work by Equarius Risk Analytics indicated that a portfolio tilt towards companies with lower waterVaR risk outperformed portfolios purely based on market cap, had higher return:risk ratios and lower active return risk.   Validation of this sectoral research (electric utilities, steel, mining) using portfolios with cross-sector allocation strategies will aid in tilt portfolio construction strategies using waterVaR-factor weighted smart betas.

Peter Adriaens is CEO of Equarius Risk Analytics (www.equariusrisk.com), a financial risk analytics firm addressing needs in the financial services industry.   For more information, refer to padriaens@equariusrisk.com

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