Sustainable investing—taking environmental, social and governance (ESG) considerations into account in asset management—has shown a steep evolutionary path over the last two decades. Philosophies, methodologies, data and practitioners have flourished, resulting in a wide range of approaches, experiences and results, which have often tended to reinforce the beliefs of both proponents and opponents of ESG. We are proponents, but we also recognize that there is more than enough room for various perceptions, misconceptions and plans of action.
One of the reasons for a long period of confusion and debate around sustainable investing has been ethical investing, an investment style that has been around for much longer. This approach simply excludes products, services and behaviours that do not comply with an investor’s particular ethics from the investable universe. These ethics could be religious, ideological, health- or community-based, and the resulting exclusions may have no direct link at all with the quality of the economic activity underlying the investment. The usual financial analysis, security selection and portfolio construction follow only after these ethical exclusions. Although in the last two decades there has been growing appreciation that excluding specific activities can reduce negative tail risks by removing potential future liabilities that are not yet fairly priced, overall, investment professionals and academics have tended to label these strategies as sub-optimal for risk-adjusted return. Exclusions-based strategies have shown very mixed alpha-generation results over time. The smaller investment universe leads to fewer diversification opportunities, and this additional risk has no ex-ante return compensation. Furthermore, because ethical investing has no specific role for financial analysts on its ESG element, they have generally shown a lack of interest in applying their skills to this type of strategy.
A much broader and more positive perspective on sustainable investing started to develop towards the end of the 1990s. This was partly driven by increasing societal recognition of global pollution, abuse of natural resources, human rights issues and unequal wealth distribution, ultimately leading to the initiation of the United Nations Millennium Goals in 2000. The result was a more holistic approach to ESG investing, which aims to assess individual corporates and their business models on both positive and negative contributions to sustainability, across all three ESG pillars. The amalgamation of indicators and insights resulted in top-line corporate ESG ratings from various external service providers, such as Sustainalytics, MSCI and ISS. Corporate management teams that were early to adopt the type of reporting and analysis that these new ESG investors and agencies demanded seemed able to improve their profile and earn a valuation premium, to the benefit of their shareholders and lenders. This premium did not last long or evolve into a structural source of alpha for asset managers, however, due to arbitrage, the dated and backward-looking nature of these data, as well as corporate “green washing” that substantially watered down the insights and added value of this ESG information. The fact that ratings from the different external providers were highly uncorrelated, often inconsistent, and exhibited size and sector biases also made them unreliable to use as the basis of alpha generation. They also tend to relate to corporate policies, structures and intentions, rather than rating companies on “walking their talk” and truly implementing material ESG enhancements. Finally, most methodologies assess corporates on enormous numbers of indicators that are identical, regardless of which industry a company is in. This leads to lack of distinction between corporates, but also a lack of sufficient attention by data users on the ESG elements that are truly material for each individual company. No wonder financial analysts and portfolio managers have generally been hesitant to use these ratings and assessments in their daily search for proprietary insights and alpha.
By contrast, we deem a detailed bottom-up approach towards ESG, focused on what is most material to specific business models and their role in their respective value chains, as a highly effective tool in the search of meaningful ESG insights and alpha. From this perspective, we actually see ESG as a tool to distinguish excellent corporate quality, and to better understand a company’s competitiveness and ability to adapt to change. Conceptualized and approached in this way, there is a clear incentive for financial analysts to integrate ESG research into their work, and all portfolio investment activities, more fully. This is what we have been promoting and doing for years. Now, we see the focus in everything ESG moving rapidly in the direction of hard and detailed numbers, clear targets and real change, for corporates as well as for asset managers. This is driven by regulators—think of the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and various requirements of the U.S. Securities and Exchange Commission (SEC)—as well as supported by broad societal demands, which are reflected in, for example, the United Nations’ Sustainable Development Goals (SDGs) and the growing allocation towards E and S in government budgets. Exciting times are awaiting us in ESG research and investment, with challenges that we are taking on in the best possible way.
