ESG must be more than following ratings

clock • 4 min read

The flow of capital around the world has been reshaped by the dawn of responsible capitalism. Investor capital is now receding more rapidly than ever before from companies who are seen to behave irresponsibly.

We know companies have not sufficiently prepared themselves for the mounting regulations and shareholder pressure they will face under an intensifying ESG lens. If firms have failed to evolve their businesses, they will see a deep impact in performance.

Indeed, we are already seeing value destruction ignited by ESG issues. In the wake of January's deadly Vale S.A.'s Brazilian mining disaster that claimed 240 bodies, Sustainalytics, the ESG ratings agency, immediately pulled their recommendation which contributed to a price plunge of 28%.

Avoid the herd
We are encouraged that pressure is mounting on companies to improve their ESG metrics. However, we believe the hot money flowing into companies with a higher ESG score is stoking a bubble. For us ratings are a crucial part of the investment process if you are integrating ESG risk, but they are only one tool that investors can utilise.

If investors adopt a herd-like mentality and only invest in large cap best-in-class companies displaying the highest ratings, it can lead to valuations getting detached from reality. Larger capitalisations currently dominate ESG-labelled funds and investors often invest - without realising it - in the same way, multiplying risk. This could lead to a dangerous bubble and impede the global transformation to more sustainable investing.

Sustainable long-term investment must combine analytical ESG tools such as ratings, and fundamental bottom-up active investing to analyse where cash generation and return on equity can justify valuations.

While the integration of ESG is less prevalent in the fixed income space, asset managers are beginning to make strides in the bond world. We have collaborated with the World Bank and issued two bonds linked to the UN's Sustainable Development Goals (SDGs). Applying ESGs in fixed income is not an easy task: between governments and companies, we must consider all the complexity and myriad factors of debt issuance.

To affect positive change, we must assess impact and exercise engagement. But even then, as bond prices remain sensitive to currency and external factors, it remains a deeply complex task. However, recommending a bond just because it bodes well for a portfolio return objective is no longer acceptable. Embracing sustainable investment is not a race; in the fixed income world it is about making incremental gains through a combination of analysis and engagement.

Going the extra yards
The consideration of ESG ratings is a must, not only in managing investment funds but also in the advisory functions. Plugging the non-financial data into traditional analysis adds value, but it is important to walk the extra mile. For us, this means understanding what are the future challenges a company might face and how they will affect earnings.

The exercise becomes more onerous when we consider smaller-sized companies, as most are chronically under-research by analysts. But ignoring smaller firms in the sustainable chain avoids a rich vein of alpha opportunities, as micro and small caps are the cradle of entrepreneurs.

Many offers today are packaged around environmental issues - something which is increasingly aligned to investor objectives. For example, if we want to be active and successful in fighting climate change, we need to think creatively and design new products that will reward investors - the basic principle of investing - and support companies that want to pass down a better future and a healthier planet to the next generation.

Ultimately it must start with good governance, and a real motivation to reduce societal and environmental impact. But it must be borne in mind that it is always more difficult to maintain a high ESG ratings score than reshaping a company to improve a low score.

At Syz, we decided to embrace the change by inviting our clients to express their views and requirements in sustainable finance. Huge differences exist between regions, cultures and personal aspirations. Understanding the origin of our clients' capital and their source of revenues is helping us to design customised portfolios to prevent risks in an increasingly homogenised market and address the great problems of our age.

Carole Millet, senior investment advisor & fund selection at Banque SYZ