Finding the ESG common ground.
Lynn Strongin Dodds explores the difficulties in analysing and integrating ESG issues into qualitative and quantitative research.
Although the incorporation of environmental, social and governance (ESG) factors into financial research was gaining momentum, Covid-19 is expected to accelerate the pace. ESG funds have outperformed many of their mainstream peers during the market downturn although the lack of standardisation, uniform definitions and quality data will continue to pose challenges.
Numbers crunched by Schroders showed that during the market crashes throughout the latter part of March – when more countries including the UK went into lockdown – the MSCI ESG Leaders indices outperformed their mainstream counterparts in most geographies, albeit modestly in several instances. The UK was the most striking example with the FTSE 100 ESG Leaders index returning -27.3% year-to-date compared to -33.7% for the FTSE 100 index. The MSCI ESG Leaders indices target companies that have the highest ESG rated performance in each sector of the parent index.
Research by Bank of America Merrill Lynch also found that the top 20% of ESG-ranked stocks outperformed the US market by over five percentage points during the recent sell-off. This was not just down to a sector bias – ESG stocks are less likely to be in energy sector, and more likely to be consumer staples/healthcare – but persists on a sector-adjusted basis.
Hurdles to overcome
As a result, there is greater demand for detailed ESG research, but one of the biggest stumbling blocks to ESG analysis is, unlike financial information, corporates may volunteer but are not required to report on most types of ESG activity. Even if they do disclose their activities, there are different ways to report. Take the auto industry. As Ian Love, head of SEI Investment’s Institutional group for EMEA and Asia points out, “car companies could get high marks for their electric car ambitions, but recent studies show that battery production and electricity provision can be carbon intensive in nature and it could take roughly 150,000 kilometres of use before these cars effectively lower emissions.”
These issues help explain the results in the report by NMG Consulting and sponsored by Franklin Templeton which confirmed the lack of acceptable policy frameworks and reliable data hampered the buyside from integrating ESG research into their portfolios.
“There are fund managers that have built fairly substantive proprietary structures and models, but in general, there is a lack of common standards and reporting metrics which hampers the ability to compare metrics and measures across companies,” says Gill Lofts, EMEIA sustainable finance leader at EY. “This leads to discrepancies and variations across the industry. “However, ESG is moving up the priority list and the focus is increasingly about mandatory reporting that not only points out the risks, but also flags how companies can create sustainable businesses and long-term value.”
Third party providers
Currently, the major conduit for information is from external data vendors and ratings agencies although industry experts advise caution. “The high reliance of investment managers on aggregated ESG scores from third-party vendors is both surprising and disconcerting given that correlations are low, transparency on backfilled, corrected, and extrapolated data is poor,” according to Dr Tom Steffen, a quantitative researcher at Osmosis Investment Management. He adds that several of the data points are also generated by qualitative and subjective means which makes analysis difficult.
Mark McDivitt, head of ESG for State Street’s investment servicing businesses, also points to a study from the Massachusetts Institute of Technology – “Aggregate Confusion: The Divergence of ESG Ratings,” which looked at the parallels between five prominent ESG rating agencies – KLD, Sustainalytics, Video-Eiris, Asset4, and RobecoSAM. On average they were 0.61 compared to 0.99 of the credit ratings from Moody’s and Standard & Poor’s. “The result is that although there are several people in the space, no one has perfectly nailed it,” he adds. “However, I think the definitions will continue to evolve as the data gets better.”
Vanessa Bingle, Alpha FMC’s co-manager of its ESG proposition also believes that, “the lack of quality data and disclosure is a red herring but should not be used as an excuse for not moving forward. The data can be imperfect in other areas of investment research and yet investment decisions get made. What we are seeing is that instead of solely having specialist ESG teams, ESG training for all analysts is beginning to emerge and be thoroughly embedded into the investment decision process. This is because they are looking at these issues in all of their investments and not just specialist funds.”
Forging their own ESG paths
Not surprisingly, it is the larger fund managers as well as the ESG buyside stalwarts who are farthest along the curve. This is reflected in the NMC study which found that the more urbane investors integrated ESG into 91% of their equity portfolios while those at the medium and lower end of the sophistication spectrum incorporate ESG into 69% and 41% of their respective equity portfolios.
In general, most of the veterans in the field use third party data as a starting point, but they have also developed their own models and methods. Although the metrics may differ, there is a mutual focus on the financial material impact ESG issues have on a company bottom line, revenue growth, margins and risk. They, of course, vary according to sector, supply chain management, environmental policy, worker health and safety, and corporate governance are common measures.
“Materiality has become increasingly important but everyone has their own way of incorporating ESG into financial models,” says Archie Beeching, director of responsible investing at Muzinich & Co, which is developing a heat map highlighting the most material factors for every sector. “For select best-in-class strategies we do apply thresholds and companies have to meet certain scores and we feel it’s important to be clear about the thresholds that you set. The important thing is you need to do your homework on ESG. You will always need external data providers but you have to do your own ESG analysis and integration. It is by no means perfect but it is a journey that all fund managers need to take.”
Some managers like PanAgora Asset Management, though, have their own proprietary quantitative models that help identify ESG friendly companies that can also deliver alpha. “We would look at measures such as cost of capital to see which areas have a lower and higher cost of capital,” says Mike Chen, director of portfolio management, adding that ESG-rated companies tend to have less exposures to systematic and company-specific risk factors, which can lead to a lower cost of capital. “We would also look at how a manager is being compensated – is it direct ownership or stock options – and the behaviour of the company’s stock.”
Technology, of course, is also playing an important role. Fund managers such as State Street have developed their own ESG scoring system and leveraged artificial intelligence, machine learning and natural language processing to create a more comprehensive picture. “For example, you can look at a company report and it will tell you that they are doing great on ESG issues,” says McDivitt. “However, we are leveraging AI to look at social media and see what people are saying about the company. Are their employees happy or are they really making improvements on the environment side?”
While the buyside navigate their way through the ESG landscape, industry and trade groups have launched their own plethora of initiatives to help guide them. On the international stage, they include the International Integrated Reporting Council (IIRC), Global Reporting Initiative (GRI); the Climate Disclosure Standards Board and the Task Force on Climate-related Financial Disclosures.
Nationally, the US has its Sustainability Accounting Standards Board (SASB) while regionally there is the European Union’s recently agreed taxonomy on sustainable investing – which has been called the world’s first regulatory benchmark for green financial products. It may only cover a small part of the investment universe – the environment – but market participants see it as a step in the right direction.
In the UK, the Investment Association has introduced an industry-wide definition on responsible and ESG investing in an attempt to create a common language for advisers, fund managers and consumers based on a consultation with more than 40 investment management firms representing £5trn of assets. it defines and explains the terms “Stewardship”, “ESG Integration”, “Exclusion”, “Sustainability Focus” and “Impact Investing”.
Looking ahead, Nadia Humphreys, a business strategist for sustainable business and finance at Bloomberg believes that the industry is in a transitional period but that there is more pressure on fund managers to look more closely at the material impact of ESG issues. “There needs to be greater transparency and disclosure,” she says. “Investors should kick the tyres, ask more questions and dig more deeply into the methodology that their fund managers are using for their investment decisions.”