Reducing Water Risk Pays Dividends: Market Signals from waterVaR-Weighted Portfolio Allocations (updated)

Reducing Water Risk Pays Dividends: Market Signals from waterVaR-Weighted Portfolio Allocations (updated)

Posted by

Counter to carbon risk, which highly depends on government policies to help set the price on an intangible asset and drive operational costs to make a difference, business water risk is financial risk from the start.  Our work on waterVaR and waterBeta analytics has exposed water risk impacts on asset pricing and volatility.  These can inform environmental or investment policies.

In our prior work we have described waterVaR (Value-at-Risk) metrics that describe volatility risks in stocks and portfolios due to water exposure.  This risk is informed by a waterBeta, which quantifies the ‘dampening effect’ or elasticity of this risk, which is very company-specific (much like financial betas).  Recently, we suggested that waterVaR data for water-intensive companies could be used as so-called ‘smart beta’s’ for portfolio allocations.  The premise is that allocations based on risk-indicators result in lower volatility in the portfolio, and outperform traditional allocations such as market cap- or price-based allocations.

If true, this would constitute a market signal that quantifies how the management of corporate water risk exposure pays off.   This information would be invaluable to portfolio managers, who need risk data to call on companies prior to making allocation decisions:  high water risk exposed companies’ allocation would decrease, while those of low water risk exposed firms increase.

Until now, there are no such data available in the ESG and peer reviewed literature.  The trade-off between ESG performance and investment returns is difficult to analyze, both theoretically and empirically, primarily because of the multi-dimensionality of the ESG concept.  The prevailing academic consensus is that there is insufficient information in ESG – environmental data to make financial performance-based decisions.  In essence, ESG-based stock allocations are often values-based decisions, informed by corporate environmental/social risk and risk management metrics.    However, despite this information, there is no basis in fact that demonstrates that low carbon or water efficient companies command a financial performance premium, or exhibit lower volatility in asset pricing.

Empirical findings have shown a positive, but weak, relationship between environmental and financial performance (profitability, ROI or market value).    An HSBC analysis of ESG-weighted portfolios, reported in the Financial Times, showed that there is no penalty from ESG-based investing, as compared to unranked portfolios.  A 2014 MSCI report on the financial performance of low carbon indices indicated that annualized returns, volatility and return:risk ratios were no different from the MSCI ACWI benchmark.  Taken together, the argument could be made that, since there is no penalty for ‘green investing’, ESG-weighted portfolio allocations are beneficial.

The implications may be that certain (environmental) ESG attributes might be value-relevant but they are not efficiently incorporated into stock prices.  The challenge is then how clear market signals can be extracted as indicators for good environmental performance.  If there is no market signal, or no risk pricing of the asset, how can investment decisions be informed for risk management?

Enter smart beta

electric-util

Sometimes known as advanced beta, alternative beta or strategy indices, smart beta can be understood as 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.

Using a theoretical $1 bn portfolio comprised of 17 electric utilities with highly variable waterVaRs and market capitalizations, we decided to execute on a thought experiment.  The hypothesis was that leading risk indicators such as waterVaR may portend lower volatility risk for the company, and may then on an annual basis deliver better returns on investment.

Hence, in a side by side comparison, stocks were allocated on a market cap-, stock price-, and a waterVaR-weighted basis, and the volatility as well as returns were calculated.  We reported earlier on the top and bottom performers of these companies, both in terms of waterBeta and waterVaR.

The comparison in the figure indicates that waterVaR-weighting did not track market cap- or stock price-weighting.  For example, companies such as Duke, EDF, Exelon and Iberdrola have a significantly reduced allocation based on waterVaR (high water risk volatility), whereas PPL, Cheung Kong, Northeast, and Red Electrica exhibit enhanced allocations (low water risk volatility).   Indeed, our calculations indicated that the latter companies exhibited the lowest waterVaR of all companies, while EDF, Exelon and Iberdrola garnered the top three highest waterVaRs, ranging from $30-280MM. in fiscal 2011.

Utility-allocation-performance

The impact of the allocation shift on performance of the hypothetical portfolio is shown in the table, and indicates that returns of waterVaR-based allocations are positive and in excess of average market performance during 2011.  The Dow was up 5%, while the S&P 500 was flat.  Market cap-based allocations underperform the market.  The volatility risk  favored waterVaR-based portfolios by a margin of 0.7%.  Stock price-weighted allocations fared better than market cap-based, in terms of annual returns (11.31%), but still are 2.7% below waterVaR-based allocations.  Volatility risk carried a 1% risk premium over waterVaR.

Portfolio-weighted-performance-700x155

Clearly, this was a thought experiment to test a hypothesis, and broader implications should not be inferred until more comprehensive datasets are analyzed and testing/validation is done on commercial portfolios.  Nevertheless, investment allocations based on quantitative risk metrics relevant to the ESG discourse should be considered going forward, given their policy design and asset risk pricing value.

At this time, Equarius Risk Analytics is expanding its database across industry sectors (electric utilities, steel, mining, food and beverage, O&G), and is structuring agreements with leading financial data providers and NGO to extract market signals.  These signals are expected to inform policy designs, drive corporate water risk management investments, and deliver above-market financial returns as smart beta allocation metrics.

Dr. Peter Adriaens is CEO of Equarius Risk Analytics, a financial IT firm focused on risk analytics related to equities and portfolios exposed to natural resource constraints.  He can be reached at padriaens@equariusrisk.com or at www.linkedin.com/in/peteradriaens/

FacebookTwitterGoogle+Share