Understanding ESG Investing
In our White Paper, “The Corporate ESG Guide: A 360 View on the Current Landscape and Trends”, we gathered industry views from leading market participants in order to provide clarity on key ESG topics. This is the first in a series of articles focusing on individual topics covered in the White Paper, starting with ESG Investing.
ESG has experienced a sharp rise in popularity in recent years, and is now attracting the attention of corporates, investors, and regulators alike. In addition, the ESG investing universe has been rapidly expanding, with estimated assets under management of over $30 trillion (GSIM 2018). With ESG rapidly becoming a dominant market trend and the development of a variety of ESG investing strategies being deployed, many companies are unsure how to address changing investor demands. Understanding how investors incorporate ESG into their decision-making process is an important first step.
Why is ESG important to investors?
Most investors feel the way companies address their impact on the environment, their employee relationships, consumers, and wider society, directly impacts the resilience of their business models. With the onset of climate change and the growing environmental awareness by the general public further increases the importance of ESG to company valuations and their licence to operate. This is reflected by 69% of investors stating that incorporating ESG in their investment analysis helps them to form a more long-term view of an investment proposition.
Andrea Carzana, ESG European Equities Fund Manager at Columbia Threadneedle Investments, illustrated how financial and ESG considerations come together to form a complete picture of a company: “They are two sides of the same coin: one side is the financial fundamental analysis, where we look at the competitive advantages of each company and how they impact the company’s growth, cash flow and the return on capital employed. At the same time, it is important to look at non-financial data, and that is the ESG element – We look at internal governance practices, environmental policies and those elements that are in control of management. Controversies are pressure points on management and how they react is a very good window into the culture of management. We are not only concerned about the controversy itself, but more about the management reaction to it and what they did to mitigate it, to make sure it won’t happen again. We say that those are two sides of the same coin because by looking at non-financial and financial factors, you can actually invest in a company for the long term.”
Passive ESG investing
While active investors manage the majority of ESG assets, passive ESG funds are growing exponentially with inflows of over $12 billion in 2019 (US SIF, 2020). Passive investors usually construct their portfolios based on ESG indices offered by data providers such as MSCI, FTSE, STOXX, Bloomberg, and others. Some of the popular ESG investing strategies include ESG integration, screening (positive or negative), thematic funds, and impact investing. In passive investing, these strategies are realised through screens or filters that are applied to the original universe of index constituents. For example, the MSCI ESG Universal Index filters out companies with low ESG profiles (based on MSCI ESG ratings). Other ESG indices can exclude companies in certain industries or target a particular sector (such as Low Carbon or Water Management). One criticism of Passive managers is their perceived reliance on ESG data providers which tends to result in a preference for large-cap companies in the financial and communications sectors, which produce high-quality disclosure and do not belong to high-emissions industries.
Active ESG investing – market perspectives
In the White Paper, we spoke to some of the most prominent active investors about their approach to ESG. ESG integration was the most popular investing strategy, according to 92% our interviewees. This approach typically involves including ESG factors alongside traditional financial metrics into their investment analysis to form a more comprehensive view of a company. ESG integration is already adopted or is in the process of being adopted by 85% of investors, across all of their assets (not just thematic ESG funds). However, ESG factors do not always play a decisive role under this approach. My-Linh Ngo of BlueBay Asset Management explains that the final investment decision depends on the risk/reward profile of a particular investment.
My-Linh Ngo, Head of ESG Investment at BlueBay Asset Management illustrated how ESG factors are integrated into investment analysis: “For the majority of our funds our focus is ESG integration, which is making sure that we systematically identify and evaluate ESG risks to understand their investment relevance and materiality. These are ‘ESG-aware’ funds if you like, rather than being ‘ESG-orientated’ ones. If we don’t think the ESG factor(s) are investment relevant or material, then for such funds the ultimate decisions will depend on the investment case. But if we think they could be investment relevant or material, we would then look to understand whether these risks are reflected valuations to determine if investors are being sufficiently compensated for that risk. If not, we may not invest. The focus is on understand the risk and reward profile of the investment opportunity.”
ESG integration takes the biggest part of the ESG investing universe, with SRI funds (usually an exclusionary investment approach, avoiding investing in controversial industries or companies with a low ESG rating) and impact investing being the second and third most popular strategies. Maria-Elena Drew, Director of Research for Responsible Investing at T. Rowe described the breakdown of the ESG universe: “Looking at data from investments, we broke down ESG funds into different categories: incorporating ESG to enhance your performance – that is a significant portion of the market today (in the active market); SRI universe, applying positive or negative screening – that is a smaller part, but pretty sizeable; impact investing is very small, but is growing very fast.”
Impact investing generally refers to investing in companies that produce measurable contributions to resolving societal or environmental issues. This sub-section of ESG investing is likely to grow exponentially as ESG integration becomes standard and the generational change drives demand for more environmentally focused investment products.
Request a copy of “The Corporate ESG Guide: A 360 View on the Current Landscape and Trends” here.