Using ESG Investing As Downside Protection

Let’s start with something obvious:

Stocks do not always go up. But on average and over time, they generally do. Yes, this may be a simplistic concept. But sometimes it bears repeating.

As your portfolio matures, are you prepared to ride out occasional losses, dips and downturns? Or do you prefer to be more active, seeking ways to find higher returns, and even going against strong headwinds in turbulent economic climates?

All this is part of a good strategic assessment, which a seasoned wealth advisor (such as Signet) will offer. What’s more, they’ll also work to understand your time horizons, specific needs and personalized investments.

Regardless of your approach, you deserve to know what’s going on. And to feel in control of your financial goals.

At Signet, we realize that all investors require a rate of return – at a level of risk they can accept for the long term. That’s why a downside protection strategy is attractive to many investors. 

On average, the annual return of the S&P 500, since its inception in 1926, is approximately 10-11%. But during corrections, recessions and depressions, your portfolio could potentially experience 10-50% declines.

Put another way, it’s not if we’re going to see markets decline. It’s when.

As experts in ESG – as well as SRI – investing, we’re finding that using ESG data could enhance your risk assessment, and protect against the downside of these market declines.

So, what does downside protection actually involve? How can we align these strategies with ESG (Environmental, Social and Governance) principles?

The Upside of Downside Protection:

Downside protection, as a concept, is simple: Find ways to guard your portfolio against losses.

Downside protection, as a practice, can be more complicated: don’t let your investments lose money.

Strategies for downside protection aim to reduce the frequency and/or magnitude of capital losses, resulting from significant asset market declines. Some of these involve adjusting a portfolio's market exposure to limit the impact of potential losses from market downturns.

In other words, when the market goes down 30%, or if a trade starts to turn against you in the short-to-medium-term, are there ways to take less of a loss?

The upside of downside protection is that your account might experience fewer overall red days. Then again, the downside could be that you’re trying to “time the market”, rather than simply spending time in the market.

Here are some typical downside protection moves and methods for active traders:

-Using stop-loss orders to sell at a specified (stop) price

-Putting trailing stops in place to protect gains and guard against losses

-Shorting closely-related securities

-Purchasing assets that are negatively correlated to the asset you’re hedging

-Writing covered call options against your portfolio

-Even diversification itself is a broad-based strategy that can reduce risk, while maintaining return

How ESG Can Help Provide Downside Protection:

Have you forgotten 2020? Pretty unlikely. But, hopefully your portfolio has. Although markets made a bull run straight into 2021, what happened in 2020 is a good illustrating tool.

When the coronavirus pandemic was priced in by markets, the three major indices saw a 30%+ decline. But while the broader market took months to recover, some sectors stayed high – namely tech and telecom-type securities, and a basket of stocks related directly to COVID-19.

This, in essence, is the nature of downside protection – looking 1-2 moves ahead, to pick investments that not only mature over time, but protect against losses.

So, how does this relate to ESG – and your portfolio?

Some Reasons Why ESG Has Emerged As  

We can sell our point, but you probably want facts. And with ESG, the proof is in the non-GMO pudding:

Recently, fund research firms and managers have said that ESG-screened indexes – which include broad sustainability indexes, as well as those tracking specifics such as renewable energy – largely outperformed in 2020 and over the last five years, while also offering more downside protection.

You might not just think of ESG as a downside move, but also as a total recovery strategy, as the future of the global economy comes into sharper focus.

Some more thoughts:

1.) Good Leadership, Good Results

Blue-chip-type companies that are well-governed tend to have high-performing, modern executives, as well as pods, labs and departments that are devoted to thinking about things like contingencies, risk and business continuity. Put simply, companies that take smaller losses tend to reward shareholders.

2.) ESG Is Geared For This:

At its core, ESG was born of reactionary response. Though its inception was largely impelled by an impending environmental crisis, the goal of ESG is to look ahead. If, in fact, we’re facing headwinds and governmental measures such as fuel sanctions, resource shortages, or government mandates, ESG-focused companies should be more geared to respond quickly.

3.) Investing Based On ESG Lowers Risk: 

According to some, funds that invest responsibly outperform peers on risk measures 55 percent of the time. It also shows funds that invested responsibly have a stronger Sortino ratio, which measures the risk-adjusted return of an investment, than their peers 72 percent of the time, suggesting they have better downside protection.

4.) Institutional Investors Are On Board:

Of the many reasons to consider ESG, one of the biggest is that ‘smart money’ is moving that way. Institutional investors, which have an outsized impact on overall market performance, say they’re implementing ESG investing for a number of reasons. Here are a few: to align investment strategies with organizational values, influence corporate behavior, minimize headline risk, generate higher risk returns over the long term, make the world better, follow a mandate in the investment policy, benefit from new sources of diversification, and … you guessed it … enhance downside protection.

Are you thinking about lending some downside protection strategies to your portfolio?

As always, the choice is up to you and your Signet advisor.

How Signet Can Help:

It’s our mission to provide investment resources and strategies to clients and financial institutions, helping them develop a greater knowledge and passion for sustainable, responsible and impact investments.

Let us help you find your mark with our experience.

Fine Print:

The return may be lower than if the adviser made decisions based solely on investment considerations. All investing involves risk, including loss of principal. No strategy assures success, or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.)

SOURCES:

Important Disclosures:

Socially Responsible Investing (SRI) / Environmental Social Governance (ESG) investing has certain risks based on the fact that the criteria excludes securities of certain issuers for non-financial reasons and, therefore, investors may forgo some market opportunities and the universe of investments available will be smaller. Stock investing includes risks, including fluctuating prices and loss of principal.