By Hamlin Lovell, NordicInvestor

ESG is most extensively applied to equity investing, but can be applied across all asset classes and strategies. ESG currency investing is at this stage a nascent strategy. Record Currency Management has already developed three ways of integrating ESG into currency investment processes, and is exploring different evolving perspectives on the topic.

The genesis of Record Currency Management’s ESG currency strategy was not a currency mandate per se and this is not entirely surprising. Investors’ ESG policies do not explicitly specify currencies, but investors such as GPIF in Japan, or CalSTRS in the US, make ESG integration part of a portfolio-wide policy.

A large US investor was going through an RFP process that required ESG incorporation across the whole portfolio, which implicitly included currencies. We were successful in the RFP and joined them on the journey. We wanted to be at the forefront of developing ESG currency strategies”, says Aaron Cantrell, Record’s Head of Economic Research, who is based in New York. “We were the first currency manager to join the UN PRI. We are active members of the PRI, including in its Working Group on global macro hedge funds”, he adds.

However, the manner in which ESG integration in currencies is reported and understood is often at odds with established frameworks, including questions on ESG policy, as these are not always germane to currencies.

In RFPs or our UN PRI reporting, for instance, it is sometimes difficult to fit our ESG currency strategies into the standard boxes.”, says Katy Husband, Record’s Sustainability Officer.

Emerging Markets Currencies

One approach to ESG currency investing is to integrate country-level ESG data as a factor guiding allocation.

ESG data helps us to look beyond prices, beyond economic data, to detect sources of value and of risk that have not yet appeared in financial data…”

according to Cantrell. Record in 2018 launched a systematic ESG factor in its emerging market currency strategy, based on a composite index developed in-house. “We used the UN SDGs to map the range of concerns important to investors and policymakers, then used fundamental and statistical criteria to focus our list in a way relevant to currency,” says Cantrell.

One example of a currency that has been an underweight since launch is South Africa’s Rand. “South Africa scored poorly mainly on the social side, though its governance and environmental metrics also fell short”, says Husband. “This Rand underweight worked well since the Rand has depreciated over this period. The tilts are focused on the negative side of a skewed distribution”, says Cantrell.

Frontier Markets

Record also launched a frontier markets currency strategy in 2019, which needs to apply ESG somewhat differently. Cantrell adds:

Systematic integration does not work as well because there is not as much data over the universe, which is also harder to trade. So the ESG integration needs to be more hands-on…”

Developed Markets

The approach is being broadened out to include developed market currencies. Record is of the opinion that the line between developed and emerging market currencies is too rough a distinction, because it no longer correctly delineates the variation in terms of liquidity, risk, yield, etc. “One research project is disaggregating the characteristics that define return and risk into factors, which include valuation, yield, and ESG. Over time, ESG will become a recognized risk factor for DM currencies as well”, says Cantrell.

Multi Asset Strategies

Record has recently expanded into multi-asset strategies, run by John Floyd, Head of Macro Strategies and Portfolio Manager, who previously ran his own global macro hedge fund. Says Cantrell;

Our multi-asset strategies are traded on a discretionary basis, which means that systematic integration of ESG is not the best way to apply ESG. Instead, higher frequency and alternative data, including ESG data, is used to inform expectations of asset prices…”

Engagement with Counterparties

Another angle for applying ESG across all of the above currency strategies (and others) is to focus on the instruments used to obtain exposure, which are usually forward contracts with counterparty banks. Husband is leading a program that assesses banks’ ESG performance on criteria such as their internal policies, scope 3 carbon effects, and financing of carbon intensive sectors, based on data, reports, and external analytics including news and controversy reports. “Data from ESG ratings agencies such as Sustainalytics and RobecoSAM, and other data such as gender pay gaps and carbon emissions can be added. We use more than one source because there is some subjectivity and differences of opinion. Banks traded with include US, Canadian and Australian banks”, she says. “The list of criteria for appraising the banks will likely expand as the EU taxonomy leads to more factors being incorporated into regulated disclosure. This all feeds into a ranking of banks, upon which the quarterly discussions and engagement with banks’ sustainability teams are based. The idea is that we could temporarily suspend trading with a counterparty that had poor or deteriorating ESG ratings, though this has not happened yet”, she adds.

Incidentally, though banks are the main counterparty, we are also pursuing alternative peer to peer arrangements…”

For some sorts of passive currency hedging strategies, engagement with counterparties may be the only avenue for pursuing ESG, though in other cases there could also be some latitude to adjust hedge ratios based on ESG criteria.

Academic research and collaboration

ESG currency investing is a novel concept and thinking is evolving fast, with Record wanting to stay at the forefront of the discourse. There is no fixed template but Record is keen to continue applying its insights on the connections between ESG and currencies.

As well as UN PRI, Record is working with Swiss Sustainable Finance, the Centre for Financial Innovation, and UK impact thought leadership group Pensions for Purpose. In terms of internal ethics around trading FX, Record belongs to the FX Global Code. Internally, Record also has an ESG committee and affinity networks.

Record has also engaged in a number of academic collaborations, including projects aiming to identify material ESG factors across a range of asset classes. One example of this is an ongoing collaboration with Dr Witold Henisz, founder of the ESG Analytics Lab of The Wharton School of the University of Pennsylvania, in the development of pedagogy and analytics.

Readers should watch this space for more developing approaches to ESG and currencies.