Recent regulatory developments suggest that environmental, social and governance (ESG) investing is neither a fad nor a subjective enterprise. Rather, it has become a critical part of day-to-day investment management. Global investor commitment to ESG- and impact-themed investing evolved from a question about why ESG is important to how it can be most efficiently implemented.
By Guillaume Mascotto
A growing body of research supports a positive relationship between high ESG characteristics and improved investment outcomes. However, as an investment factor, ESG continues to lack uniform definitions and a solid methodological baseline for security analysis. There are no generally accepted accounting principles (GAAP) for ESG.
The explanatory effect of ESG on returns in the context of stock market crises also remains subject to debate. As a result, popular guidance based on ESG overlays (e.g., ESG analysis separated from fundamental analysis) or inserts (e.g., top-down SRI screens) runs the risk of obscuring which ESG issues are truly financially material and for what time horizon they will affect issuers.
ESG assessments that are both risk-based and forward-looking can help assess an issuer’s downside ESG risk propensity as well as capture ESG upside potential."
We believe that a bottom-up ESG integration approach that is investment-led and focused on materiality is optimal. In our view, such an approach can increase portfolio diversification and maximize the integration of both ESG quality and alpha-related inputs.
We believe this results in a 10-step process to achieve a successful ESG integration strategy:
1. Be flexible and investment-led
ESG factors can be integrated in multiple ways. An ESG integration framework should therefore be flexible and align with the particulars of a given investment strategy. For example, ESG teams may want to consider the following:
- Providing investment teams with the right tools and in-house ESG expertise to implement an integrated approach or combination of approaches best suited to their investment processes.
- Allowing investment teams to tailor the ESG integration process according to asset class, style, time horizon, opportunity set and client objectives.
Tying business planning to specific, measurable, achievable, relevant and time-based (SMART) goals to help incentivize the investment organization to commercialize ESG solutions the market demands
2. Build strong partnerships with fundamental analysts
The number of ESG specialists aside, systematic ESG integration cannot be achieved unless fundamental analysts and ESG specialists work together. We aim not to substitute fundamental analysis but rather to augment it.
Financial and ESG information must be considered concurrently . The objective is to ensure investment analysts and portfolio managers participate in the ESG assessment by allowing them to provide input regarding the financial materiality of ESG issues to which their issuers are or could be exposed.
3. Focus on industry and macroeconomic context
Identifying ESG issues (aka ESG key issue mapping) should consider, and be corroborated by, the macroeconomic context and any relevant industry-specific competitive forces.
Given that not all sectors are exposed to the same macro ESG issues, our ESG team works with our in-house sector leads to isolate the issues that could potentially alter long-term, sector-specific competitive forces.
4. Identify downside risk and upside potential
Although many investors think of ESG primarily as a risk input, it can also represent upside opportunities. Therefore, analysts should focus on both the ability of the issuer to manage potential ESG-related costs and/or liabilities and its aptitude for setting the firm's strategic direction. It is also important to consider time horizon, as exposure to an ESG risk or opportunity may not materialize for five, 10, or even 15 years.
ESG assessments that are both risk-based and forward-looking can help assess an issuer's downside ESG risk propensity as well as capture ESG upside potential.
5. Achieve an equilibrium between ESG quality and returns; avoid unintentional biases
As ESG demand grows, investors should be aware of the potential risk of a crowded ESG trade. Once a good ESG trade becomes public, its success may attract other investors, eventually leading to concentration and overpricing.
As such, investors should redouble efforts to be creative in unearthing ESG rising stars (i.e., issuers in earlier stages of business inflection or on the verge of improvement following a business misconduct controversy). Defining the risk appetite around ESG is key to helping provide diversification in the portfolio and reducing bias.
6. Remain data intensive while considering variant ESG views
Investment teams should consider third-party ESG ratings and artificial intelligence and understand the drivers underpinning these opinions and signals. This is similar to how they consider credit ratings, sell-side research and quantitative analysis. However, they should do so while generating variant views to exploit any potential disconnects in external ESG research or quantitatively driven data.
7. Build your own ESG framework
The financial materiality of ESG analysis should be supported by proprietary research based on combined ESG and financial variables with a focus on investment implications. Proprietary ESG assessments should also apply to various asset classes and be dynamic, capturing whether an issuer's risk management practices are improving or worsening over time.
To effectively scale ESG integration efforts, proprietary ESG research should ideally be centralized and made accessible to all investment teams.
8. Embrace long-term stewardship
Engage with issuers that have weaker ESG performance relative to their peers but show room for improvement. This helps portfolio managers gain a more thorough understanding of the company's approach to ESG risk management, including controversies and remedial actions.
Use engagement to encourage an issuer to increase transparency on material ESG issues. If engagement fails to yield positive outcomes, portfolio managers could escalate their concerns by supporting ESG proxy resolutions, reducing the holding's weight, or divesting from the issuer, among other methods.
9. Take a solutions-driven approach
There is no one-size-fits-all approach to ESG. As client needs and regulatory developments continue to evolve, so should the capabilities of investment managers. A manager's ESG program should therefore be flexible and regularly reviewed against industry best practices and market trends. This may help managers to provide multiple ESG solutions in all investment disciplines, subject to client needs.
10. Be passionate
Any new enterprise, regardless of the field, requires passion to succeed. Passion is the cornerstone of what American Century calls ESG "grit," a trait that all of its ESG analysts share. The millennial generation has fully embraced, with passion, the importance of ESG issues. They are likely to expect genuine passion on the part of their asset managers as they seek investment solutions in an effort to secure their long-term financial viability.
The investment community's conceptual understanding of ESG and its role in investment decision-making is continually unfolding. We believe accounting for ESG risks and opportunities is in line with fiduciary duty—it is not disconnected from financial returns. To successfully achieve this alignment, we believe investors must take an investment-led approach focused on materiality and fundamental analysis. They must also remain flexible to evolving client-specific values and guidelines.
Guillaume Mascotto is vice president, head of ESG and Investment Stewardship at American Century Investments