Picture by SugarHima shows wooden fake wind generator to illustrate benchmarking problems

Benchmarking problems (Researchpost #88)

Social and Ecological Topics

Tax avoidance: Global Profit Shifting of Multinational Companies: Evidence from CbCR Micro Data by Clemens Fuest, Stefan Greil, Felix Hugger, Florian Neumeier as of May 26th, 2022 (#30): “Our analysis uses firm-level data from country-by-country reports of more than 3 600 multinational groups operating in 238 jurisdictions … The companies in our sample report 7% (30%) of their global profits in countries with effective average tax rates below 5% (15%), but only 0.4% (10%) of their employees and 3% (20%) of their tangible assets are located there. We find that globally, these firms reduce their tax burden by EUR 53 billion (15% of their overall tax payments) by shifting profits to low tax countries. … Globally, 60% of profit shifting is carried out by the 10% largest multinational firms” (p. 30/31).

Greenwashing evidence: Net Zero Stocktake 2022 – Assessing the status and trends of net zero target setting across countries, sub-national governments and companies by Net Zero Tracker and others as of June 2022: “Overall, the transparency and integrity of existing net zero pledges are far from sufficient to ensure a timely transition to global net zero greenhouse gas emissions by mid-century. … Overall, we found that only around half of the companies with net zero targets have some type of interim greenhouse gas (GHG) emission reduction target. Given the scientific imperative of roughly halving global emissions by 2030 in order to give a reasonable chance of holding global warming to 1.5°C, this is unacceptably low. Moreover, about two-thirds (456 out of 702) of corporate pledges do not yet meet minimum procedural standards for target setting” (p. 5/6).

Responsible Investments and benchmarking problems

ESG literature review: Sustainable finance: A journey toward ESG and climate risk by Monica Billio, Michele Costola, Iva Hristova, Carmelo Latino, and Loriana Pelizzon as of April 27th, 2022 (#193): “Besides the important M&A processes that have been observed, the ESG rating industry has faced the offspring of six major ESG reporting frameworks aiming to guide ESG disclosures: the Carbon Disclosure Project, the Climate Disclosure Standards Board, the Global Reporting Initiative, the International Integrated Reporting Council, the Sustainability Accounting Standards Board, and the Task Force on Climate-related Financial Disclosures. … Most ESG assessments are still very different in terms of indicators measured (definition of ESG materiality), information sources, and the weights applied to different criteria. …. a very large majority of studies concludes that positive ESG ratings are associated with: an improvement in credit ratings, a reduction in CDS spreads, and a decrease in costs of equity capital and debt” (p. 47/48).

Brown banks? The Carbon Bankroll – The Climate Impact and Untapped Power of Corporate Cash by the Climate Safe Lending Network, The Outdoor Policy Outfit and Bank FWD as of May 17th, 2022: “… for Alphabet, Meta, and PayPal, the emissions generated by their cash and investments (financed emissions) exceed all their other emissions combined” (p. 4). “… across the Group of 20 leading industrial and developing nations, banks have $13.8 trillion of exposure to carbon-intensive sectors, which constitutes 19% of on-balance sheet loans. … … the average carbon intensity per unit of cash deployed by the US financial sector is 126.03 ktCO2e/billion USD. … a typical passenger vehicle emits roughly 4.6 metric tons of CO2 per year, meaning that for every $1 billion in cash a bank deploys, it generates comparable emissions to 27,398 vehicles’ annual emissions … in February 2022, 13 of the world’s biggest non-financial companies cumulatively held cash and investments that exceeded $1 trillion” (p. 9).

Abusive German finance? Dirty profits 9 by Facing Finance as of May 18th, 2022: “This report illustrates seven examples of financial flow between 14 financial institutions on the German market and 22 companies that have violated, among others, the right to health, to remedy, or to free prior and informed consent of Indigenous Peoples and of communities with customary tenure rights … The research reveals an extremely high volume of business for ten banks and four life insurers vis-à-vis the 22 companies, amounting to more than 46 billion euros. While Glencore and Airbus were the largest recipients of corporate loans, the financial institutions also have particularly large holdings in the pesticide companies Bayer and BASF as well as in the oil and gas company Total Energies. On a positive note, eight banks and two life insurance companies had no financial interests in the companies studied (p. 5/6). … Since 2018, eight banks on the German financial services market have provided a total of more than 31 billion euros to 14 of the selected companies for the financing of their business models. This amounts to 67% of the identified financial relationships. … Roughly 90% of the identified finance volume is accounted for by UniCredit (HypoVereinsbank), Deutsche Bank, Commerzbank and ING” (p. 6).

Greenwashing evidence: Mutual funds’ strategic voting on environmental and social issues by Roni Michaely, Guillem Ordonez-Calafi, and Silvina Rubio as of Feb. 25th, 2022 (#25): “Environmental and social (ES) funds in non-ES families must balance incorporating the stakeholder’s interests they advertise and maximizing shareholder value favored by their families. We find that these funds support ES proposals that are far from the majority threshold, while opposing them when their vote is more likely to be pivotal, consistent with greenwashing. This strategic voting is not exhibited in governance proposals, by ES funds in ES families or by non-ES funds in non-ES families, reinforcing the notion of strategic voting to accommodate family preferences while appearing to meet the fiduciaries responsibilities of the funds” (abstract). My comment: Divestments bewirken mehr als Stimmrechtsausübungen oder Engagement | SpringerLink

Positive ESG Bonus? Executive Compensation Tied to ESG Performance: International Evidence by Shira, Igor Kadach, and Gaizka Ormazabal as of May 3rd, 2022 (#404): “… we find that ESG pay is more common among larger firms that exhibit higher volatility … our findings show that the proclivity to implement ESG pay increases with existing public commitments to reduce carbon emissions, the level of institutional ownership, and certain board characteristics. … ESG pay adopters tend to achieve lower carbon emissions and improved ESG ratings. … the adopters of ESG pay experience a stronger association between improved ESG performance and the magnitude of the annual executive bonuses” (p. 30). My comment see Pay Gap, ESG-Boni und Engagement: Radikale Änderungen erforderlich – Responsible Investments (Blog) (prof-soehnholz.com)

Profitable traceability? Lifting the rug – How Traceability in Textiles Improves Financial and Sustainability Performance by Planet Tracker and Segura as of June 9th, 2022: “Traceability and sustainability go hand in hand. Better traceability allows for better measurement of inputs and outputs, both vital to support the measurement of key sustainability metrics. Implementation of traceability tools can improve production efficiencies and therefore profitability. … We estimate implementation of a traceability system could improve the industry’s (defined as brands and retailers) net margin of around USD 80 billion by USD 3 – 6 billion per year. … The tools for companies to have full traceability through their supply chain exist …” (p. 4).

Limited plastics engagement: Breaking the mould – Business-as-usual is a high-risk strategy for the EU plastic industry by Planet Tracker as of May 30th, 2022: “Banks, brokerage houses, insurance companies and investment advisers have a EUR 689 billion (USD 750 billion) equity position in the EU27 + UK plastics production sector, across basic chemicals, intermediates and plastic resins” (p. 25). “In the last five years, … only 9 resolutions have been discussed at AGMs. This demonstrates that investors are largely disengaged from the problems associated with plastic production. Our analysis of 990 corporate bonds and loans issued by the world-leading plastics manufacturers found only three linked to decreasing plastic pollution. None of the sector’s 40 green bonds or loans are linked to reducing plastic pollution in the EU” (p. 4).

Green real estate: Green Urban Development: The Impact Investment Strategy of Canadian Pension Funds by Alexander D. Beath, Maaike Van Bragt, Sebastien Betermier, and Yuedan Liu as of May 20th, 2022 (#179): “… large Canadian pension funds … are uniquely involved in the market of direct real estate transactions and implement a strategy that consists of internally developing and greening local urban properties. … Canadian pension funds play a leading role in driving the green development of major Canadian city centers. … Canadian pension funds are able to create a win-win that combines high risk-adjusted return and sustainable urban development“ (p.30).

Traditional investments and benchmarking problems

Positive panic: Economic Narratives and Market Outcomes: A Semi-supervised Topic Modeling Approach by Dat Mai and Kuntara Pukthuanthong as of Jan. 18th, 2022 (#258): “We … extract narratives from nearly two million and seven million Wall Street Journal and New York Times articles, respectively, over the past 150 years. … We find that Panic and an index constructed from all narratives … can positively predict market returns and negatively predict market volatility  … As a robustness check, we extract narratives from WSJ, and the most important narrative is Stock Market Bubble. Stock Market Bubble is a negative stock market predictor” (p. 37/38).

Risky monetary policy: Investment funds, risk-taking, and monetary policy in the euro area by Margherita Giuzio, Christoph Kaufmann, Ellen Ryan, and Lorenzo Cappiello as of Oct. 13th, 2021 (#45): “We provide evidence of search for yield from fund investors, who flow into riskier fund types in response to accommodative monetary policy shocks. This is particularly the case following monetary policy shocks that directly target the long-end of the yield curve, such as quantitative easing policies. Some of this search for yield may result in flows into funds investing outside of the euro area. … Search for yield by investors is amplified by asset allocation decisions of managers who tend to rebalance their portfolios away from increasingly low yielding cash assets. … Increased demand for risky assets may improve financing conditions for the real economy but may also result in a build-up of risk within the fund sector. Increased liquidity risk-taking by fund managers may be a particular cause for concern, as this may decrease the sector’s capacity to deal with large investor redemptions during a crisis scenario and provide stable credit to the real economy” (p. 33).

Corporate data issues: Missing Financial Data by Svetlana Bryzgalova, Sven Lerner, Martin Lettau, and Markus Pelger as of May 13th, 2022 (#458): “In our representative data set of the 45 most often used characteristics, more than 70% of firms are missing at least one of them at any given point of time. We show that firm fundamentals are not missing-at-random, but display complex systematic patterns” (p. 46). My comment: Traditional investors have not complained much about this point but cry foul about missing ESG data

Benchmarking problems: Index inefficiencies? The Avoidable Costs of Index Rebalancing by Rob Arnott, Chris Brightman, Vitali Kalesnik, and Lillian Wu as of May 6th, 2022 (#327): “Traditional capitalization-weighted indices generally add stocks with high valuation multiples after persistent outperformance and sell stocks at low valuation multiples after persistent underperformance. For the S&P 500 Index, in the year after a change in the index, additions lose relative to discretionary deletions by about 22%. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 basis points (bps).” (abstract). My comment: I use equal weighting for direct equity portfolios

Benchmarking problems: Wrong benchmarks: Self-Declared Benchmarks and Fund Manager Intent: Cheating or Competing? by Huaizhi Chen, Richard Evans, and Yang Sun as of May 6th, 2022 (#35): “We examine the selection of fund self-declared benchmarks. While the incidence of style mismatched benchmarks is high at the beginning of our sample (41% of fund assets/34% of funds), it declines significantly over time. …. In examining why funds ‘correct’ their benchmarks over time, we find that investor learning, institutional investor governance, product market competition and fund company risk management all play a role. Lastly, we find that funds overseen by entrenched managers are more likely to use a mismatched benchmark“ (abstract). My comment: Before setting tracking error targets, investors better examine if the benchmark is correct, also see ESG-Investments: Warum weder aktive Fonds noch ETFs ideal sind – Responsible Investments (Blog) (prof-soehnholz.com) and EU Klimaindizes und ESG Indexverordnung: Offizielles Greenwashing? – Responsible Investments (Blog) (prof-soehnholz.com)

Institutional herding: Unpacking the Rise in Alternatives by Juliane Begenau, Pauline Liang, and Emil Siriwardane as of May 11th, 2022 (#91): “We document a large and heterogeneous shift by public pensions into alternative investments (hedge funds, private equity, and real estate) since 2006. … our results are consistent with a sizable shift in beliefs changing the composition of the risky portfolio. … investment consultants explain nearly 25% of the variation of which pensions shifts into alternatives. … we also document evidence of peer effects in the sense that pensions are more likely to invest in alternatives if their neighbors do” (abstract).

Crisis un-diversification: Crisis Stress for the Diversity of Financial Portfolios – Evidence from European Households by Dorothea Schafer, Andreas Stephan and Henriette Weser as of May 7th, 2022 (#11): “This paper answers the question of whether the Global Financial Crisis and the subsequent European debt crisis affected the diversity of European households’ financial portfolios. … We find that households with risky assets responded to the twin European financial crises with lower levels of portfolio diversity. The loss in diversity was caused by a flight to safe and liquid bank accounts at the expense of mutual funds and stocks. …. The richer households are, the better diversified financial portfolios they have” (p. 25).

Alternative Investments and Fintechs

Over-leveraged: Leverage in Private Equity Real Estate by Jacob S. Sagi and Zipei Zhu as of April 6th, 2022 (#156): “We review the scant academic literature on the use of leverage in institutional private equity real estate (PERE) investments …. The bulk of available evidence supports the view that leverage, as used by high-risk PERE funds, does not adequately compensate limited partners for the risk that it adds” (abstract).

Good Fintech: Fintech: Financial Inclusion or Exclusion? by Yoke Wang Tok and Dyna Heng as of May 24th, 2022 (#42): “…greater use of fintech is significantly associated with a narrowing of the class divide and rural divide but there was no impact on the gender divide” (p. 4).

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