Navigating philosophical Waters


Navigating Philosophical Waters

All approaches to Responsible Investing (RI) seek to discourage reckless behavior and encourage long term constructive policies regardless of short term profit motives. Implementing this can be expressed in a variety of ways depending on an investor’s primary motivation. Some solutions can hold a very tangible impact such as thematic investing (renewable energy, water, agriculture etc…) but be limited in scalability as they force allocators into a specific sector exposure that may be too volatile. Other approaches such as Ethical investing, will take a moral stance towards certain sectors placing this above other considerations which may restrict the potential investor base. Being an active owner is also an essential approach in the toolbox that can be applied across all exposure types. Scalability is an issue however as this is a resource intensive effort that requires investors to choose their battles. The key to adoption by mainstream investors lies in striking the right balance between ideology and opportunism and convincingly conveying this. Taking a forward looking approach to ESG integration as opposed to merely a compliance one, yields a stronger link to performance generation. Conveying this convincingly however, requires a more sophisticated quantitative approach rather than just relying on descriptive material

 

MotivationData setManager inputPerformance Implication
Ethical List of CompaniesPassive ComplianceSub-optimal dueto constrained universe
Reputation Proven controversial companiesPassive ComplianceLikely performance drag
Risk Management Potential controversial companiesAssess controversy riskLower fat tail risk
ESG based complianceGlobal ESG scoresBast-in-class as an RM toolOblivious to changes in ESG
Active ownership Critical issuesEngagemetPositive on long duration
ESG Integration Granular KPI data/proxiesAssess materiality of ESG inputsAdditional alpha generation

Profitability and responsibility

Corporates started adopting CSR best practices at the executive level earlier than their investors started focusing on ESG in an integrated manner. This is mainly due to the recognition from management that certain issues do have a material impact on their bottom line. They increasingly incorporate sustainability at the heart of their decision making rather than relegate the function to an investor relations exercise. Similarly portfolio managers motivated mainly by returns will seek to incorporate as many data points as they can be they financial or non-financial that may prove material in anticipating positive changes.

Engaging further up the food chain

Being an "active owner" need not be restricted to shareholders of companies. Fund Investors should also engage in an active dialogue with portfolio manager encouraging a better management of their capital. Much of this dialogue currently revolves around ensuring a proper governance structure of the fund, with some asset owners even taking an active role in choosing board directors, or encouraging managers to tackle ESG issues inherent within their holdings. Whilst these efforts are necessary and commendable, there is also new scope to engage with managers in how they select stocks in the first place: A detailed analysis of the style of a manager and of their ability to capture any available alpha associated to ESG trends can form the basis for a convincing dialogue with portfolio managers. When faced with a quantitative demonstration of their own ability to anticipate E,S or G improvements and how this can be linked to returns, such a dialogue moves beyond one based on compliance, to one based on a mindset shift based on gaining their buy in.

An evolving price discovery mechanism

Across the value chain of money, an inflection point is being reached in top level adoption of ESG integration. Encouraging as this may be from a responsible investor's perception, the fact this is simultaneously happening across a variety of players means these factors are increasingly getting priced in much faster. As perception is often more important than reality in financial markets, material changes in ESG issues at a company will be seen to affect prices significantly enough to be taken into account in the decision making process by even the most cynical of investors.


ESG ratings or Integrated sell side research

The adoption of ESG integration into the mainstream would not be possible without the continued steady progress we have witnessed in ESG data. The effective use of this research relies on having an appreciation of which data sets are leading or lagging indicators. Sell side brokers and securities analysts that integrate ESG factors into their research do so with a subjective forward looking perspective focusing on how ESG issues could hold under-appreciated insights into future risk or opportunities the market is not yet pricing in. Rating agencies on the other hand undertake a more objective backward looking assessment of how a company scores on a variety of KPI’s according to their own matrix. The latter is more comparable to credit rating agencies such as Moody’s or Fitch in their approach that do not pertain to hold some predictive powers of an issuer. Both sets of data have an important role to play

Anticipation is what earns the fees

Credit managers do not select securities with AAA ratings hoping these will outperform. They select poorly rated corporates in anticipation of improvements in credit quality that the market will reward. As company fundamental improvements go hand in hand with ESG improvements, it would be reasonable to expect Equity managers to also gravitate towards companies that they expect will improve their ratings rather than focus on those that are already have a high score. More often than not well rated companies such as Unilever are also those that have the broadest and most material improvements. When focusing on performance however, it is the improvements rather than absolute levels of ratings that are important. Many “best in class” strategies will arbitrarily exclude poorly rated companies and miss out on the opportunities where (new?) management recognizes that they need to implement changes. These are likely to be the most dramatic changes which will also be the greatest market outperformers. This is where a manager earns his fees


Separating the how from the what

Responsible investing being an emotive subject, it can be difficult to segregate what a company does from how they do it when undertaking and ESG assessment. Holding true to linking sustainability to returns, it would be advisable to draw a line between the two; unfortunately this tends to be a thick grey line rather than a fine red one. Having an oil company expand into Sub Saharan Africa may be seen as negative by those that frown upon the expansion of extractive industries (the "what"). This is likely to be ignored by the market that may see it as profitable expansion by management.

On the other hand, if they do so with a continuous focus on employee safety, proper governance and anti-corruption procedures (the "how"), the market is likely to reward this in the long run as it provides a more sustainable approach than their peers and more likely to boost longer term profitability.

A pragmatic return focused approach to ESG integration requires the portfolio manager to be in charge of ascertaining materiality. To be fairly judged by investors, separating the “how” from the “what” remains critical in this assessment.

Reporting non-financial performance

Transparency is of paramount importance in maintaining the necessary level of trust between a principle and an agent. How to build that trust on the other hand, requires a more intricate use and analysis of this data that aims to go beyond traditional static reports. Factor analysis and detailed attribution including ESG metrics, are important in being able to have a dashboard view of one’s current position and risk exposures. To build trust however, this is not enough…

Modern technology allows transparency to go beyond traditional reporting and be used as a veritable scan of a manager’s DNA allowing investors to diagnose what decision making elements are implicitly used by managers, including the anticipation of ESG improvements. This Forward Looking Assessment of Material Externalities, (FLAME) is the proprietary technology at the heart of Prius’s investment process.