Volume 20, No. 2, Second Quarter 2022
ESG Investing
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Article
ESG, Investing, and Corporate Finance: Some Basic Questions
This paper is devoted primarily to asking questions about the implications of the growing focus on ESG (environment, social and governance) for investing and corporate financial policy rather than offering answers. Many of the questions raised here were anticipated by Milton Friedman in his classic New York Times article. Although many critics now dismiss Friedman’s article as stogy and dated, I argue that the critical questions he raised remain unresolved today and lie at the core of much of the debate regarding ESG.
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Article
Sustainable Investing From a Practitioner’s Viewpoint: What’s in Your ESG Portfolio?
Many investors have shifted their asset allocations to account for Environmental, Social, and Governance (ESG) issues. While we welcome this shift from an ethical perspective, the financial and non-financial benefits of ESG investing as well as best practices for portfolio construction are subjects of heated debate. We look at aspects of the debate through a series of practical examples. First, we illustrate the trade-off between risk control and unwanted exposures in energy and “vice" stock exclusions, which have exhibited inconsistent performance at a 10-year horizon. Next, we show how recent underperformance of a gender lens portfolio has been confounded by technology stocks. Finally, we explore how ESG score disparities lead to important differences in portfolios constructed with these scores. In aggregate, our examples point to the inherent complexity of ESG investing, which will benefit from better data, transparency, customization, and an acknowledgement that doing good does not necessarily lead to doing well. An important theme throughout this paper is that everything should be made as simple as possible, but no simpler.
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Article
Sustainable Alpha in Sovereign and Corporate Bonds
We construct fixed income portfolios for sovereign bonds and corporate bonds with sustainable insights. The climate methodology for sovereign bonds can be applied as an overlay on any benchmark and tilts toward sovereigns more prepared with the climate transition and away from those which are less prepared. The tilts reduce sovereign carbon emissions in line with the Paris Agreement. For corporate bonds, we investigate three sustainable signals that predict excess returns: environmental, social, and governance (ESG) scores of corporations scored across various rating and sector buckets, firm carbon emission intensities, and corporate commitments that signal reduced carbon emissions.
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Insight
Financing Vaccines for Global Health Security
Recent outbreaks of infectious pathogens such as Zika, Ebola, and COVID-19 have underscored the need for the dependable availability of vaccines against emerging infectious diseases (EIDs). Prior to the COVID-19 pandemic, the cost and risk of R&D programs and uniquely unpredictable demand for EID vaccines discouraged many potential vaccine developers, and government and nonprofit agencies have struggled to provide timely or sufficient incentives for their development and sustained supply. However, the economic climate has changed significantly post-pandemic. To explore this contrast, we analyze the pre-pandemic economic returns of a portfolio of EID vaccine assets, and find that, under realistic financing assumptions, the expected returns are significantly negative, implying that the private sector is unlikely to address this need without public-sector intervention. However, in a post-pandemic policy landscape, the financing deficit for this portfolio can be closed, and we analyze several potential solutions, including enhanced public–private partnerships and subscription models in which governments would pay annual fees to obtain access to a portfolio of stockpiled vaccines in the event of an outbreak.
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Insight
Toil and Trouble, Don’t Get Burned Shorting Bubbles
Bubbles are among the most puzzling and controversial phenomena of financial markets. Although rare, their cumulative impact on both investor returns and the broader economy can be great. One particular question that has motivated research is why shrewd short
sellers don’t prevent excessive price increases.
The “limits to arbitrage” idea argues that correcting inefficient market prices is neither
easy, cheap nor riskless. The “rational bubble” literature identifies situations in which being long the bubble is a better trade than being short, even if investors know for certain the bubble will pop. And there is a theory that bubbles only inflate after the shorts have
suffered significant losses.
We examine the “short subprime” trade from 2005 to 2008 to evaluate these and other explanations. We argue that the short subprime trades had more risk than is commonly appreciated. We discuss how the opaque and illiquid nature of subprime mortgages deterred some investors from purchasing CDS contracts and note that other investors assessed the risk of counterparty failure, government intervention and unknown time horizon to be sufficient enough not to purchase CDS contracts.
In addition, we describe how factors such as performance convexity and credit convexity made the subprime short more profitable than most ex-ante calculations suggested. We also outline why the subprime short trade was ineffective at reining in the subprime bubble and how buying subprime after the crisis was an equally, if not more, attractive trade that potentially did more to mitigate the harm of the bubble. Looking back at the last major bubble with a decade of hindsight yields insights that might be helpful to market participants and policy makers thinking about future bubbles. -
Practitioner's Digest
Practitioner’s Digest • Vol. 20, No. 2
The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.
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Insight
In Memoriam—Louis A. Simpson
Louis A. Simpson
December 23, 1936–January 8, 2022 -
Book Review
The Future of Money: How the Digital Revolution is Transforming Currencies and Finance
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.