Written By: Stephen Hearle
Stephen Hearle of Nordea Asset Management UK explains how to evaluate the three ESG dimensions and assesses their respective effects on a company’s risk profile
Global equities can be a volatile asset class. Faced with a multitude of factors – size and liquidity, currency exposures, regulation and underlying business conditions, to name but a few – an active manager needs a diverse set of metrics. To avoid being caught out, portfolio managers need to ensure they have a suitable toolbox to analyse the full set of risks.
Fundamental analysis has many tools available, and whether managers choose a single primary approach – such as a growth or value-based – or tend towards a more flexible style, portfolio managers aim to construct portfolios with the optimal risk-return profile. To do this, they need to identify the valuation measures that they feel best evaluate the potential returns from a given business. They also need to consider all the relevant risks. One of these, which is growing in investor awareness, is ESG (Environmental, Social and Governance).
ESG is becoming increasingly prominent in the investment world, and although ESG is entering the fixed income arena, its greater impact for the moment falls in the equity sphere, where shareholders are best able to influence companies. As concern about climate change has become widespread and the UN’s Sustainable Development Goals (SDGs) have drawn attention to numerous global sustainability issues, individuals are recognising that their investment choices can be a tool to effect change. In addition, regulatory change driven by the EU’s Action Plan “Financing Sustainable Growth” will work further to bring responsible investment to the forefront of both end-investors’ and managers’ minds. However, many investors still see ESG as a limiting factor on their investment universe – and potential returns – rather than a source of risk or return in its own right.
To properly value a business, one needs to include ESG risks
Valuation techniques have been the subject of academic study for the last century. Risk research followed, and even now risk factors are still being identified. A Morgan Stanley whitepaper published last year analysed the returns and downside deviation of over 10,000 mutual funds and ETFs over the period 2004-2018. The authors found that while returns delivered by sustainable funds (as identified by Morningstar) were in line with their more traditional counterparts, the downside volatility – the risk – was lower to a statistically significant level. Where risk levels are high, such as with global equities, the identification of a new factor that can help reduce risk without compromising returns seems tantalisingly close to investment’s holy grail.
Getting ESG risks out of your portfolio
Within the responsible investment world there are a multitude of approaches, not least depending on which ESG factors a fund is focused on. Most environment funds, for example, would not lay strong emphasis on social issues like child labour or tobacco use. However, at the highest level, we can identify two primary approaches to responsible investment. The more simple approach involves screening to exclude businesses operating in ways or markets the investor wishes to avoid. The deeper approach is ESG integration, which starts with screening and exclusions but carries out additional research at the company level to allow a more nuanced selection or exclusion decision.
Screening funds for “bad” companies is an obvious step for an ESG fund, and each fund will have different views on what constitutes bad: is it alcohol, tobacco and gambling, is it human rights abuses and contraventions of other global “norms”, or is it fossil fuels and nuclear? All of these carry risks (future litigation from addicts, reputational damage, and clean-up costs after environmental disasters), so even the most simple exclusions can reduce risks for investors. However, at its most extreme, pure screening could result in exclusions of significant parts of the market and thereby limit not only the potential performance of a fund but also its ability to diversify.
Screening and excluding companies with certain exposures makes very good sense, but it is necessarily backwards looking and doesn’t allow for any engagement with companies to encourage them to change.
ESG integration can solve both of these issues. A deeper analysis of companies’ ESG performance produces shades of grey, where dialogue with company managements allows the investor to better understand the corporate direction of travel. This gives a fund the scope to exclude the poor ESG performers while encouraging companies to improve and enabling the portfolio managers to consider the different angles within ESG performance.
Even so, a global equity fund ultimately needs to define its investment universe with yes or no decisions of what to include. How can a manager boil down the multi-faceted elements of ESG/responsible investment/sustainability into a single risk measure?
Finding comparability in ESG risks
The answer is: with many inputs. We don’t rely on a single fundamental measure when evaluating a share, but we do identify a handful of key figures that give us a framework against which to compare stocks. The same thing needs to be done – and can be done – when looking at ESG factors. Just as we might use different tools to value businesses in different sectors, such as asset value for property companies versus some form of cash-flow or yield-based valuation for slow growers like utilities, we need to do the same thing for ESG.
The first step, just as when making fundamental assessment of companies, is to identify which measures are the most relevant and important to each business. Investors are faced with a wealth of data and factors that can be taken into account under the heading ESG. While some of these factors can be important to a particular company’s performance, others are not. The relative importance of ESG factors varies from industry to industry, from company to company and from country to country. For example, water pollution and labour rights can be central to a manufacturer, while the main problem for a software provider can be data protection. Understanding the materiality of ESG factors is crucial for the analysis of the ESG profile and the position of the company. Standard evaluations are of little help here and the processing of the data collected must be adapted to the integration into the investment process. So instead of taking a unified approach, a responsible investor should aim to develop an ESG analysis framework that is specific or really essential to a company and its profitability.
Building an ESG framework
Having identified the material issues for each company, the manager needs to decide how to weight the relevant factors. Flexibility is key. Every business needs to be examined in its own right, and when building an ESG framework, the sustainability of the company’s business model is an important thing to consider. In addition to a more straightforward review of how sustainable the company’s products and practices are, we could consider the company’s revenue risk in relation to positive sustainable contributions and its innovative capacity, reflected – for example – in R&D expenditure for sustainable solutions. Understanding how a company responds to sustainability trends can lead to forward-looking insights into future risks and opportunities.
Quality of company management is another component which should feature. In addition to governance elements such as the independence of the board structure and the completeness of corporate governance practices, this should consider business ethics (e.g. whether incentivisation structures could lead to mis-selling) and the degree and transparency of ESG engagement.
Weightings amongst the more traditional “E”, “S” and “G” issues will also differ company to company. Here we could include themes such as energy efficiency, waste and hazardous substance management, labour management, human capital and supply chain management, and whistleblower functions, code of conduct and employee training. The selection and weightings of these must be based on their relative importance to the company and respective risk exposure, looking at both potential financial effects and their inherent reputational risk.
In order to gather data, the starting point must always be the company itself. Much of the data should be publicly available but some of it will necessarily come through interactions with the company, such as meetings or conference calls. Discussion with the company also gives an insight into the management’s view of ESG issues and how it is working to address them. This brings a dynamic forward-look perspective, rather than the static snapshot achieved by reliance on historic data. Nevertheless, third-party data is also valuable. A full 360 degree approach will include information from external bodies ranging from universities and NGOs to agencies such as ISS or MSCI. A wide range of inputs can deliver a clearer picture.
Flexibility brings strength
When evaluating the three ESG dimensions and assessing their respective effects on a company’s risk profile, a “one-size-fits-all” approach does not lend itself to achieving the desired success. A flexible weighting of E, S and G in a materiality matrix enables the overall risk of a company to be assessed much more precisely. This is a significant added value of true ESG integration.
Is all of this really necessary?
Whatever one’s views on the pros and cons of taking a more holistic approach to investment, there is mounting evidence that not only is ESG a potential risk factor – it also brings returns. Research from the University of Oxford (2015) looked at more than 200 academic studies, industry reports, newspaper articles and books. Among these sources, 80% showed that strong sustainability practices have a positive influence on investment performance.
In the past, many investors have assumed that ESG is a trade-off that actually limits their potential returns. Now it seems that far from being a factor that might limit investment returns, ESG might actually enhance returns, a suggestion that is well worth noting by all global equity managers. With statistics like this, even sceptics should perhaps consider ESG to be a useful tool in the global equity investment toolkit.
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1. Morgan Stanley Institute for Sustainable Investing, “Sustainable reality: analysing risk and returns of sustainable funds”, 2019
2. In: Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance (March 5, 2015)