Highlights This Month
As we enter the last quarter of the decade there are no shortage of issues for investors to worry about, all of which leave us to wonder what may be the catalyst that causes the next major market correction. These concerns range from the ongoing trade wars between the United States and China, mounting levels of global negative yielding debt, the recent inversion of the US yield curve (two year yields trading higher than 10 year yields) acting as a potential recession warning indicator, and an aging bull market.
Another issue that has recently been gaining momentum with investors is climate change. Socially Responsible Investing (SRI) and Environmental, Social, and Governance (ESG) integration have been around for many years but climate change specifically has seen increased attention from vocal environmental advocates like Greta Thunberg and more frequent Global Climate Strikes. These events lead many investors to ask what they are invested in and how they can position their investments to have impact in the issues they are passionate about such as climate change or basic labor standards. In this month’s commentary we will provide a high-level overview on Responsible Investing and the various methods of implementation utilized by investors and asset managers as well as provide some background on the recently launched Nicola Sustainable Innovation Fund.
The Roots of Responsible Investing
The roots of Responsible Investing date back to various religious groups in the 1700-1800s who held core beliefs that encouraged them to avoid investments in businesses or products involved with weapons, tobacco, or alcohol. The recent increase in interest within this area is driven by greater client demand for transparency into where and how their money is being allocated. Some of this has been brought on by changing demographic and technological trends with younger generations expecting greater and more frequent access to information as well as tailoring of their portfolios.
These younger investors will also be the likely recipients of the greatest wealth transfer in history as roughly $30 trillion from the Baby Boomer generation is passed down. Finding ways to adjust to the evolving preferences of clients is a key objective for wealth managers and Responsible Investing and ESG integration are likely to play a greater role for future generations. Other reasons for the uptick in interest in this area of investing has been a number of high-profile events such as the BP Deepwater Horizon oil spill, Volkswagen’s Dieselgate emissions scandal, and data breaches from companies like Facebook, Equifax, and Yahoo! These incidents and others have led investors and asset managers to start placing more focus on non-financial factors which may have material long-term impacts on company valuations.
Non-Financial Factors in Responsible Investing
For those less familiar with this space it may be helpful to mention some of the commonly used terms and acronyms that are often used interchangeably but which broadly encompass the inclusion of non-financial factors into the investment decision making process. Socially Responsible Investing (SRI), Responsible Investment (RI), Sustainable Investing, Ethical Investing, Principled Investing, Norms-Based Investing, Values-Based Investing, and Environmental, Social, and Governance (ESG) Investing are just some of the terms typically used synonymously.
Some examples of ESG issues commonly focused on in these strategies are:
|Environmental Issues||Social Issues||Governance Issues|
|Climate Change||Human Rights||Bribery and Corruption|
|Waste Management||Labor Standards||Executive Compensation|
|Resource Depletion||Community Relations||Board Diversity|
|Deforestation||Data Protection and Privacy||Political Lobbying|
|Water Scarcity||Employee Engagement||Board Independence|
|Biodiversity||Gender and Diversity||Whistleblower Schemes|
|Pollution||Workplace Safety||Evasive Tax Strategies|
|Energy Efficiency||Product Liability||Anti-Corruption Policies|
United Nations Principles for Responsible Investing
One of the best advocates for the growth and development of responsible investing has been the United Nations Principles for Responsible Investing (UN PRI). The UN PRI was formed in 2006 as an independent, not-for-profit organization to support investors in implementing ESG factors into their investment decision-making processes. Signatories to the PRI voluntarily adhere to six Principles for Responsible Investment which are meant to provide long-term guidance on incorporation.
Since its start in 2006, the number of PRI signatories following these principles has increased exponentially to over 2500 global signatories and almost $90 trillion USD assets under management. This signatory list includes large Canadian Institutional managers like RBC Global Asset Management, British Columbia Investment Management Corporation (BCI), and Canada Pension Plan Investment Board (CPP) as well as US managers such as BlackRock, and The Vanguard Group. Nicola Wealth signed on as a signatory in 2016.
How do Investors and Asset Managers integrate ESG’s in their portfolios?
Investors and asset managers looking to integrate ESG information into their process may accomplish this by using one or several of the following approaches:
- Bottom-up ESG integration: ESG factor analysis integrated at a position or company level. For example, focusing on companies with strong corporate governance and environmental policies.
- Top-down ESG integration: ESG integration incorporated at a more macro portfolio level.
- Best-in-class screening: greater preference is given to companies that have superior or improving ESG scores to their sector peers.
- Negative or exclusionary screening: excludes companies or sectors based on an organization or individual’s values, societal standards and norms, or other considerations. Common exclusions include companies involved with alcohol, tobacco, weapons manufacturing, pornography, gambling, fossil-fuels, and nuclear power. Some exclusion examples may be more company or sector specific such as prior human rights violations, or poor environmental policies.
- Positive screening: preferential scoring is given to companies or sectors involved in areas that are perceived to provide positive social or environmental benefits. For example, a company involved in renewable energy may be scored more positively than one predominantly involved with coal.
- Faith-based or values-based investing: investments are made to align with a person or organization’s beliefs. This approach can include the use of negative screens to avoid certain companies or products, and/or have a goal to generate positive social or environmental benefits from these investments.
- Impact investing: investments that are made with the goal of generating measurable positive social or environmental benefits as well as a positive financial return.
- Thematic investing: investments that are made based on a central theme such as changing demographics, climate change, clean energy, or disruptive technologies.
- Activism/Active ownership: participating in active dialogues with companies on ESG issues to achieve changes. Engagement can be direct with management, through a collaborative group of investors, or through proxy-voting on shareholder resolutions. The most common engagement issues are executive compensation, gender diversity, climate change, and corporate governance.
While some of these ESG strategies can be replicated passively, active management and active ownership of investments is a fundamental part of Responsible Investing.
United Nations Sustainable Development Goals
In addition to the UN PRI, the UN Sustainable Development Goals (SDGs) are another globally supported sustainability framework for Responsible Investing. The United Nations General Assembly, which includes 193 member states of the United Nations, launched the UN SDGs in 2015 with goals such as eradicating poverty and hunger, tackling climate change, increasing gender equality, and having universally available clean water for the entire planet by 2030. The 17 SDGs have metrics which can be measured year-on-year and are increasingly being utilized by impact investors. They can support investors in understanding the sustainability trends relevant to investment activity and their fiduciary duties.
How do we incorporate Environmental, Social, and Governance (ESG) into our work?
Nicola Wealth uses a bottom-up ESG integration approach to incorporating ESG principles into our investment analysis and decision-making process to encourage responsible investment practices without sacrificing performance for our clients. We are strong believers in a diversified, broad asset allocation, and we look to select investments that offer a combination of cash flow and capital appreciation potential with the least amount of risk for our clients by focusing on high-quality, well-run companies. The strength of a company’s corporate governance has been an important consideration in our investment process prior to us formally viewing it as an ESG factor. To ensure that we maintain these standards, ESG ratings and research from dedicated ESG research providers are utilized in conjunction with our fundamental analysis to identify potential material environmental, social, and corporate governance risks that are considered as part of the final investment decision. We also utilize Institutional Shareholder Services (ISS) which are proxy voting services for all of our equity holdings to make sure we are aligned with industry best practices and are actively engaged with the companies we are invested in.
On a monthly basis, we run both quantitative and dedicated ESG screens of our internally managed equity investments to monitor for changes in ratings and occurrences of material ESG controversies among our holdings. Any significant changes to holdings will be reviewed and discussed in one of our tri-weekly Portfolio Management Investment Meetings. The investment case for each position will be reviewed in conjunction with the materiality of this new information and a determination will be made.
ESG factor integration is most common in equity investing but increasingly has been working its way into other asset classes including Fixed Income and Real Estate. To date, Nicola Wealth’s ESG integration process has been primarily focused on our internally managed equity funds but as we further develop our approach we plan to incorporate this into the other asset classes and products that we manage.
As you may have gathered by now, ESG investing can be a grey area as it means different things to different investors. Using positive or negative screens is much easier to define than some of the other integration techniques. Focusing on which companies have good or bad governance can be more subjective. One of the biggest issues with ESG integration is a lack of standardized data. Third-party ESG ratings providers such as MSCI, ISS Governance, and Sustainalytics have worked with companies to try and boost their disclosure on frequently requested data points to help mitigate this, but reporting discrepancies still remain. ESG scores between these ratings providers are not comparable as they have differing ratings methodologies and processes. As much of this information is self-reported by a company, non-disclosure on items can result in a negative score from a third-party ratings provider but each year there is a greater number of companies that voluntarily disclose.
In place of formal regulatory reporting standards various groups such as the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), and the International Integrated Reporting Council (IIRC) have stepped up to provide more consistent reporting guidance to companies and investors. In addition to this we have also seen greater adoption of ESG considerations into financial analyst reports which indicates more client demand for this information and an increasing openness to provide it alongside standard financial metrics. In the future we could see sustainability data more fully integrated into a company’s standard financial reporting which would help standardize the quality of this data and allow for a more formal audit process.
By integrating ESG factors into investment decision-making, the assumption is it will inevitably affect the cost of capital over time; increasing the costs for non-sustainable businesses, and lowering the cost of capital for sustainable ones which should allow them to outperform over the long-term. One area that divides a lot of ESG-minded investors is our ongoing reliance on fossil fuels and whether or not divesting from them is the best course of action to mitigate climate change. The planned divestment of all oil stocks by Norway’s trillion-dollar sovereign wealth fund (the World’s largest) was seen by some as an indicator of a larger movement away from investing in fossil fuels. What shouldn’t be missed in these announcements is this decision, which has been pushed back and amended several times, and was largely made to diversify the country’s material reliance on oil. You have seen similar efforts by sovereign wealth funds in oil-rich regions such as the Middle East trying to diversify away from this exposure into areas like renewables without total plans for divestment.
The Divestment Movement
One of the drawbacks of the divestment movement is that it starves capital from energy companies that have strong ESG polices just as much as it does those that do not. For reference, Canada accounts for roughly 2% of global GHG emissions. Exploration and Production (E&P) companies in Canada are subject to more strict regulatory guidelines than many of their global peers, yet they are disadvantaged just the same by divestment. Another drawback to divestment is it waives the ability to engage with the company and promote change via proxy voting on shareholder resolutions. Energy companies are among those with the most to lose in the form of stranded assets by not planning for a future where the value of their extractive resources is worth less than it is today.
Renewable energy vs. existing energy sources
The costs for wind and solar are competitive in a growing amount of regions when compared to coal, gas, and other energy sources. The world will still need to rely on oil and gas for its energy needs for the foreseeable future until technology, and the cost of renewables vs. existing energy sources is superior in all jurisdictions. UN Sustainable Development Goal #7 of Affordable and Clean Energy for all emphasizes the use of renewables but acknowledges the role fossil fuels will still play in improving economic growth and quality of life in less developed nations. The understanding of this is that helping people out of poverty can be an energy-intensive process but the goal is to utilize renewables where possible. We still maintain investments in fossil-fuel exposed companies in our Nicola Wealth portfolios but we focus on those with strong corporate governance and those that proactively disclose ESG information as it shows they are more actively working in the best interests of their shareholder base.
The Nicola Sustainable Innovation Fund
Over the years, we have received increasing interest from clients to have more options to make purpose-driven investments that align with certain environmental, social, and governance standards. In many of these conversations clients expressed a desire to invest directly into companies and industries that are focused on renewable energy, clean technologies, as well as those operating sustainably. While we had made opportune investments in these areas in our existing Nicola Wealth funds, there was interest in having a dedicated strategy for this purpose. Building on that initiative, Nicola Wealth developed the Nicola Sustainable Innovation Fund, designed to be a diversified portfolio featuring industries and companies that provide innovative solutions to environmental issues, including alternative transportation and the global energy transition.
We believe these areas provide attractive investment opportunities and are likely to outpace the growth of the overall market for years to come. In order to be included in the portfolio, each investment will have to be aligned with one or more of the United Nations Sustainable Development Goals (SDGs), which aligns with our values as a signatory of the UN PRI.
The specific SDGs we will be focusing on in this fund are:
- SDG 6 – Clean Water and Sanitation
- SDG 7 – Affordable and Clean Energy
- SDG 9 – Industry, Innovation and Infrastructure
- SDG11 – Sustainable Cities and Communities
- SDG12 – Responsible Consumption and Production
- SDG13 – Climate Action
The initial investments in the fund have largely been to renewable focused utility companies (hydro, onshore and offshore wind, solar, and batteries), water and wastewater infrastructure, clean technologies, and green bonds where proceeds are directly tied to climate or other environmental sustainability purposes through independent evaluation. Given the intermittent nature of renewable energy sources like wind and solar, another area of interest for the fund has been wood pellet manufacturers which offer a cleaner base-load energy alternative to burning coal that can be used to help countries with de-carbonization targets to achieve their goals.
Over time we will also be looking for ways to invest in companies linked to alternative methods of transportation, vehicle electrification and charging. We are enthusiastic about the launch of this new fund and will be providing more information as it progresses.
Nicola Wealth Portfolio
Returns for the Nicola Core Portfolio Fund were 1.2% in the month of September. The Nicola Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.
The Nicola Bond Fund returned 0.4% in September and is +5.1% year-to-date. Interest rates continue to be very volatile with the 7 year Government of Canada bond yields moving from 1.17% to 1.37% erasing some of the duration driven returns in bond markets seen last month. Credit spreads were relatively stable during the month despite the volatility in interest rates and significant new issuance. August was the busiest month on record for new issuance with $15.4B. Most transactions were well received from buyers and were over-subscribed leading to new issuance concessions (a discount issuers provide to investors to entice them to purchase new bonds) coming in tighter.
The Nicola High Yield Bond Fund returned 0.2% in September, and is +4.9% year-to-date. The month marked a continuation of the trend of high quality issues outperforming lower quality issues. Earlier in the month, equities saw a reversal of trends with value significantly outperforming growth for a few days. The high yield market saw a parallel phenomenon with CCC’s outperforming BB’s. However, the trade was short lived and the market reversed course. Defaults in high yields continue to be muted with the exception of the energy space. Energy names have lagged the overall market considerably and are the only sector to post negative year to date returns. During the month there was an uptick in names that trade below $70, potentially signaling more defaults in the near future.
The Nicola Global Bond Fund was flat for the month (-0.02%). The Nicola Global Bond Fund’s exposure to U.S. high yield credit, U.S. non-agency mortgages and select exposure in EM (Mexican & Russia exposure) contributed to performance while duration exposure produced mixed results with PIMCO & Manulife’s U.S. duration detracting from performance while Templeton’s short U.S. & Brazilian duration exposure contributing to performance. Performance of our managers in descending order: PIMCO Monthly Income +0.58%, Templeton Global Bond -0.31%, Manulife Strategic Income Fund -0.30%.
The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.5% respectively last month. Current yields, which are what the Nicola Primary Mortgage Fund and Nicola Balanced Mortgage Fund would return if all present mortgages were held to maturity, and all interest and principal were repaid, are 4.0% for the Nicola Primary Mortgage Fund and 5.6% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 25.3% cash at month end, while the Nicola Balanced Mortgage Fund had 13.9%.
The Nicola Preferred Share Fund returned 3.9% for the month while the BMO Laddered Preferred Share Index ETF returned 3.6%. 5 year Government of Canada bond yields reversed course and rose from 1.18% to 1.4%. Fairfax joined Brookfield Asset Management by announcing normal course issuer bids for their preferred shares (or share buy-backs) which should help provide some price support for their preferred shares. BMO issued a $1B subordinated note through its Canadian medium-term note program during the month. The bond was well received and provides a fixed rate of 2.88% until 2024 and 1.18% plus the three-month Banker’s Acceptance Rate afterwards. Banks will likely continue to tap the bond market for subordinated debt issues instead of the preferred share market to help support their balance sheet as the financing is cheaper, highlighting the continued valuation discrepancy between bonds and preferred shares.
The S&P/TSX was up +1.7% while the Nicola Canadian Equity Income Fund was +3.2%. Financials were the largest positive contributor to the Index for September followed by Energy. Materials (more specifically Gold) was the largest negative contributor. The outperformance of the fund was mainly due to the underweight in Gold and underweight in Information Technology which was also weak. On an individual stock basis, the top positive contributors to the performance of the fund were Pinnacle Renewable Energy, Methanex, and SNC Lavalin Group. We took this rebound opportunity to exit our position in SNC and used the proceeds to add to existing positions. The largest detractors to performance were Wheaton Precious Metals, Cargojet, and Maple Leaf Foods.
The Nicola Canadian Tactical High Income Fund returned +2.6% vs the S&P/TSX’s +1.7%. The Nicola Canadian Tactical High Income Fund was underweight the five positive performing sectors (financials, energy, utilities, real estate & communication services) and also underweight some of the worst performing sectors (info tech & health care). Stock selection contributed the most to performance as the cyclical and value names bounced back (West Fraser Timber +13.4%, Transcontinental +11.5% & Methanex +10%). The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 62% (64.5% prior) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market. Mid-month, we took some profits and trimmed back our position in IGM Financial.
The Nicola U.S. Equity Income Fund (USD) returned +2.1% in September, while the S&P500 returned +1.9%. Within the S&P500, there was brief rotation into value, and defensive names performed well during the month, as the top performing sectors were financials and utilities. For the Nicola U.S. Equity Income Fund, relative performance from sector selection was muted as the drag from being underweight in financials was offset by the positive impact from being overweight utilities. Stock selection helped performance, as gains from Valero Energy, Newell Brands, and NextEra Energy, more than offset losses from Visa, Boston Scientific and Crown Castle. We sold two cyclical names — DuPont and AerCap, and did not buy any new names, as the portfolio continues to reduce risk at the margin.
The Nicola U.S. Tactical High Income Fund returned +3.9% vs +1.9% for S&P 500. The Nicola U.S. Tactical High Income Fund’s relative outperformance was due to stock selection within Consumer Discretionary (Tapestry +28% best performing stock in the S&P 500 Index last month, but our position was capped due to our Put Options, L Brands +18.7% & Thor Industries +23.4%), financials (Franklin Resources +10.8%) & staples (Molson Coors +12%).
The Nicola U.S. Tactical High Income Fund has been very selective in deploying capital. We were still able to generate double-digit annualized premiums with double-digit break-evens. The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow and lower leverage relatively to the S&P 500.
The Nicola Global Equity Fund returned +2.1% vs +1.7% for the MSCI ACWI (all in CDN$) Index. Outperformance was driven by our overweight in International equities and underweight the US, and strong stock selection by EdgePoint and Lazard, which more than offset drag from sector exposures, namely our large overweight in defensive consumer staples. Performance of our managers in descending order was EdgePoint Global +3.9%, Lazard Small Cap: +3.7%, Nicola EAFE: +2.5%, Global Value +1.3%, BMO Asian Growth & Income +1.1%, C-Worldwide +0.5%.
The Nicola Global Real Estate Fund was +0.9% in August vs. the iShares (XRE) +2.6%. Publicly traded REITs exhibited strong performance with the vast majority of long-term global government bond yields trading at or near 12-month lows. The dearth of sufficiently yielding investment products has seen many investors stretch for yield which has provided support for all high-yielding equity sectors. Current valuation levels are fair but further multiple expansion may be difficult to achieve. We think that the best opportunity to be in the multi-family and industrial sectors where the multi-year outlook appears strong for rental growth. Our largest publicly traded REIT position Pure Multi-Family REIT was acquired in September. We are deploying the proceeds in Asia. We also added BSR REIT in the month.
We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of September 30th, August 31st performance for the Nicola Canadian Real Estate LP was +0.4%, the Nicola U.S. Real Estate LP +1.2%, and the Nicola Value Add LP +1.1%.
The Nicola Alternative Strategies Fund returned -0.2% in September (these are estimates and can’t be confirmed until later in the month). Currency detracted -0.3% to returns as the Canadian dollar strengthened through the month. In local currency terms, Winton returned -2.9%, Millennium -0.4%, Bridgewater Pure Alpha Major Markets 3.9%, Verition International Multi-Strategy Fund Ltd 0.3%, Renaissance Institutional Diversified Global Equities Fund 2.1%, RPIA Debt Opportunities 1.1%, and Polar Multi-Strategy Fund 0.5% for the month. The losses caused by trend reversals in Winton were offset by a rebound in returns from Bridgewater which benefited from long equities in Europe, North America and Emerging markets as well as short duration exposure in North America.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Returns are quoted net of fund/LP expenses but before Nicola Wealth portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. For a complete listing of Nicola Wealth Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg. Effective January 1, 2019 all funds branded NWM were changed to the fund family name Nicola. Effective January 1, 2019 Nicola Global Real Estate Fund, Nicola Canadian Real Estate LP, Nicola U.S. Real Estate LP, and Nicola Value Add LP adopted new mandates and changed names from NWM Real Estate Fund, SPIRE Real Estate LP, SPIRE US LP, SPIRE Value Add LP.