On my usual commute to work, I recently stumbled upon a popular financial podcast talking about ESG (environmental, social, and governance) investing. As a professional in the ESG space, I started listening carefully, intrigued by what the mainstream financial media had to share and report on the topic. The degree of misinformation left me staggered: the podcast was talking about the rise in ESG considerations as a crusade, a greenwashing overreach that has not been proven as a competitive business case for companies or investors. Leaving the hefty amount of academic and practitioners’ evidence on the matter aside for a moment, I want to take the time to share some facts about how investors can strategically think about ESG integration and talk about some tried-and-tested implementation techniques in portfolio strategy. Here are some key facts that you need to know about portfolio ESG integration.
1. ESG integration vs ESG screening: what’s best?
The aim of ESG integration is to select and alter the weights of portfolio components based on relevant ESG information, without banning securities from the onset. In fact, it is a fully integrated step with traditional financial analysis at the security selection level. In this sense, ESG integration differs from an ESG screening strategy, where sustainability analysis comes as a distinct first step in the investment process and aims to restrict the investment universe based on desired exclusion criteria or positive screenings. For example, taking the issue of GHG emissions, an ESG integration strategy might allow you to increasingly under-weigh more polluting companies over less polluting companies, all the while taking into account the desired financial and diversification constraints of the portfolio. Instead, a screening strategy would completely exclude from the investment universe securities that emit more than a predefined threshold of GHG, and would do so blindly and from the onset, without taking into account other security selection criteria.
Although the use of either strategy or a combination of the two depend on the specific circumstance, ESG integration is recognized as a superior approach from a risk-return perspective, as the sole goal of the strategy is to mitigate ESG risks and/or improve returns rather than only focusing on impact considerations.
2. How does ESG integration work in practice? What investment strategies can it be applied to?
ESG integration can be applied to various mainstream active and passive investment strategies:
What is it? ESG integrated quantitative strategies aim to refine future price predictions by making an inference on the relationship between asset returns and relevant ESG factors, alongside mainstream relevant factors (e.g. value, size, momentum, yield, etc.) that systematically drive price fluctuations.
Who uses it? Arabesque Asset Management, Auriel Capital.
What is it? The goal of this ESG-integrated approach is to adjust forecasts of a firm’s financial or corporate valuation models to take into account material ESG risks and opportunities alongside mainstream firm value drivers. For example, investors might adjust cost of capital to reflect the impact of a company’s ESG performance on its firm value, or forecast the impact of changing environmental regulations on firm revenues, etc.
Who uses it? RobecoSAM, RBC Global Asset Management, Allianz Trust Investments.
Smart beta strategies
What is it? Analysts look at market factors such as volatility, quality, profitability, multiples, but also at relevant ESG information such as ESG scores, ESG momentum, ESG risk, to adjust the weights of companies included in an index. The goal is to create a portfolio that outperforms the benchmark index and/or changes a particular risk profile of the index .
Who uses it? Calvert Investments, AXA Investment Managers.
What is it? Also referred to as ‘buy-and-hold’ strategies, investors aim at closely tracking the returns of an index by buying and selling its underlying constituents. Unlike the previous examples where ESG factors are actively considered in investment decisions, ESG integration is less straightforward to implement in passive investment strategies. However, ESG integration can still be applied by passive investors that fully track an ESG/sustainability related index, as well as by passive investors that follow a partial tracking methodology and can thus adjust allocation weights based on specific ESG criteria.
Who uses it? MSCI, BlackRock, SD-M.
These different strategies highlight that investors have the potential to treat ESG issues as rigorously and successfully as usual financial information. Numerous business cases document how doing so can improve portfolio performance and optimize their risk-return profiles. Since even the more elaborate existing quantitative models can be adapted to factor-in material non-financial information, the road is paved for investors to care about material ESG, not for the sake of running a moral crusade, as one might be led to believe, but simply because it works.