IEEFA update: BlackRock to investors: sustainable portfolios provide stronger risk-adjusted returns
Larry Fink, BlackRock’s CEO has a message on climate change, not only addressed to corporate leaders, but to his firm’s clients, the staff, Boards of Trustees and financial advisors to institutional funds: “we are on the edge of a fundamental reshaping of finance.” This sweeping statement crystallizes a key issue resulting from several decades of investor dialogue on the role of sound financial decision-making in a time of change. How does an investor apply the longstanding principles of prudent investing as new facts emerge from science as well as from shifts in capital investment?
The current investment environment is changing. The application of age-old principles of prudence, care and loyalty remain the foundation of BlackRock’s new strategy. BlackRock is telling its clients: “Because sustainable investment options have the potential to offer clients better outcomes, we are making sustainability integral to the way BlackRock manages risk, constructs portfolios, designs products, and engages with companies. We believe that sustainability should be our new standard for investing.”
Here is a short list of some fundamental ways in which BlackRock is shaking up current practice as it applies its research and analytical tools to design new products that meet today’s financial challenges while also remaining prudent and reasonable. Everything old is new again.
Current Practice # 1: Sustainable investment harms financial performance. The theory: business activity that strays from the core mission of profit maximization lowers investment returns. It results in company resources being diverted to ancillary concerns that are not part of an efficient business calculation.
New Direction # 1: Sustainable investment is integral to improved financial performance. BlackRock’s declaration is blunt, sharp and clear: “Our investment conviction is that sustainability-integrated portfolios can provide better risk-adjusted returns to investors.” This conviction is rooted in financial performance. The simplest example are companies that adopt sustainable practices to improve profitability. On a more complex level, a comparison of the MSCI index with fossil fuels and an index excluding fossil fuels over most of the last ten years reinforces this idea, the potential for better outcomes.
Current Practice # 2: Quantitative assessments of past financial performance and various quantitative extrapolations provide sufficient diligence to create investor confidence in a particular investment. This convention pervades business decision-making and, more importantly, regulatory decisions.
New Direction # 2: Investment firm Mercer has produced a roadmap for investment thinking on climate and concluded that standard asset allocation strategies that are grounded solely in quantitative modeling are insufficient in this period of economic change. Qualitative factors with forward-looking implications also need to be considered as the fiduciary carries out its duty in this time of change.
Current Practice # 3: Environmental considerations are non-financial. This thinking is even acceded to by many who promote Environmental, Social and Governance thinking. At root, the belief is that air, water, land and climate can be consumed without cost, so the issue has no place on the balance sheet. When companies or countries are asked to account for environmental costs, such logic deems the issues as non-financial and consigns them to inconsequential policy discussions.
New Direction # 3: Environmental or climate issues drive liability, directly and indirectly. Moody’s has recently noted that even in Asia where coal plant dependence is likely to continue, plant operations pose substantial financial risk. Environmental and climate concerns and the deteriorating competitive position of coal plants have converged to make it a financial issue. For decades, Moody’s, like most financial services institutions, saw U.S. coal plants as financially positive, supported by local regulatory actions and limited competition. Today, it is credit positive when companies close coal plants as part of a strategic realignment of the generation portfolio toward meeting low-carbon standards.
Current Practice # 4: Markets price in risk. To the degree that environmental, climate or competitive factors surface as material risks, markets acknowledge them, and the price of a product or service rises and falls according to well-worn and understood commodity cycles. There is no need for shareholder or governmental interventions.
New Direction # 4: Market pricing is a blunt instrument. The market ignores some risks and misprices others, particularly during a time of change. This leads in the case of fossil fuel companies to significant value destruction for investors. Since 2014, the list of coal bankruptcies is long; the value destruction vast. Bloomberg reported that half of all coal companies in the United States had gone bankrupt by 2016. Since then, the number of bankruptcies has attenuated, but bankruptcies, most recently of Murray Energy, continue to rock the industry. BlackRock, one of the largest investment houses in the world, was late to the task of coal divestment and its investors suffered. In the oil and gas markets, exploration and production companies’ serial bankruptcies and value destruction have been well-publicized for five years. ExxonMobil hit a high-water market capitalization in 2007 at $527 billion. Today, its market capitalization is $263 billion.
Current Practice # 5: Shareholder responsibility is limited to the actions and financial performance of the individual companies in which they are invested. The shareholders of a company would be irresponsible if they behaved in a manner that would impair the actions of management to pursue the company’s interest in the marketplace.
New Direction # 5: Actual investment returns are based increasingly on investors being universal owners or owning the global market as a whole instead of individual companies. It might actually be sound fiduciary behavior to encourage a company or industry to shut down a line of business or dissolve completely. This is more desirable for an investor than to try to achieve the impossible by thwarting large capital shifts and changing the behavior of reluctant managers whose compensation and power rest on investment strategies that destroy value.
THE GLOBAL RATE OF RETURN DRIVES INDEXES AND INSTITUTIONAL INVESTMENT and serves as the basis for the targets adopted by many funds. Those who have participated in the markets as fund administrators over the last thirty years know that most funds had targets at or above 8%. Most funds are now below 8% and some have dropped as far as 7% and some lower.
For those without the protections of large funds, the outlook for retirement investment is bleak
And for those without the investor protections embedded in large funds the outlook for retirement investment is bleak. One investor publication puts it this way:
“INVESTORS WILL NEED TO ACCEPT MUCH HIGHER VOLATILTY to eke out small incremental units of return.” Morgan Stanley forecasts a 2.8% average annual return over the next 10 years for a 60/40 portfolio. The average has been nearly 8.0% since 1881 and about 6% over the last 20 years, after double-digit annual returns reaching as high as 16% from the early 1980s to the early 2000s.
A weak link in the downward drift of returns can be found at the bottom of the Standard & Poor’s 500. The elimination of this weak link, which are the individual companies in the fossil fuel sector, represents a reasonable response to changing financial conditions.
LIKE IT OR NOT, IT IS THE GENERAL RETURN OF THE MARKET THAT DRIVES INSTITUTIONAL RETURNS and the values that show up in monthly and quarterly IRA reports. Investors who continue to contend that the sole measure of a portfolio is a kind of arbitrary outcome from individual company performance speak prudence as those same company’s destroy value, quarter after quarter. These investors would do better with the Daily Racing Form.
Current Practice # 6: Downplaying environmental risk and legal compliance with environmental and climate mandates are the sum and substance of corporate activity. To these companies, legal compliance should be contested terrain and they have an obligation to minimize their compliance costs. Corporate activities that fall short of compliance must be managed either through partial compliance, strategic evasion or explicit efforts to seek legislative or judicial remedies. In late 2018, the U.S. Chamber of Commerce issued a report that chronicled 15 instances where fossil fuel projects were blocked due to environmental regulation and popular opposition. It singled out the fracking ban in New York State as particularly pernicious. The report was geared to efforts in Washington aimed at rolling back environmental regulation, citing these 15 examples as abuses of the regulatory system.
New Direction # 6: Environmental risk and legal compliance are value opportunities and new avenues of business. Environmental regulatory problems ARE a market signal. By seeing climate change as a value opportunity, BlackRock has asked all investors to think beyond the narrow constructs of legal fights over compliance and to look at the larger picture.
As part of its evolving outlook, BlackRock has joined a coalition called Climate Action 100+. This initiative was organized by CERES, a non-profit organization dedicated to sustainability. According to BlackRock, Climate Action 100+ is a group of investors that engages with companies to improve climate disclosure and align business strategy with the goals of the Paris Agreement. Through this affiliation, BlackRock has committed to a more consistent set of shareholder policies that support corporate disclosure on sustainable investing.
HOWEVER, IT IS PRECISELY CLIMATE ACTION 100+’S EFFORTS TO REALIGN BUSINESS STRATEGIES WHERE BLACKROCK WILL LIKELY FIND MORE VALUE. Separate from the work the coalition does on fossil fuel investments, the larger mission is to support sustainable business development. A better understanding of how companies are transitioning to a fossil-free world is critical to BlackRock’s investment thesis about value creation. By getting closer to companies on the edge of the change, BlackRock should obtain company-by-company and sector-by-sector lessons on value creation and economic growth.
With $7tn in assets, BlackRock has no intention of stopping its growth
BlackRock, with $7 trillion in assets under management, is already the largest money manager and there are no indications that it intends to stop growing. If it successfully executes this more climate-conscious strategy, it will send several very strong messages:
- To the world: Climate change is an issue that must be addressed and can be done so profitably. We are more likely to go broke by not addressing it.
- To the investment world: Wake up and reassess how you look at the responsibility of money managers to their clients and to a broader set of fiduciary standards.
- To its competitors: Our resources will now be used to facilitate better risk-adjusted returns and we plan to grow beyond $7 trillion executing it. Ignore this at your own peril.
- To investors: We are determined to stay on the cutting edge of protecting and building your assets. Invest with us.
- To people looking to feel more comfortable about choosing finance as a career: You have a home at BlackRock.
Time will tell whether BlackRock can deliver on these big promises. But the firm has continued to apply the standards of prudence that have guided the market for hundreds of years and also changed the nature of the dialogue about what constitutes a responsible investment today and changed it for the better.
Tom Sanzillo is IEEFA’s director of finance.
*This commentary was revised on February 2, 2020.
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