ESG Investing For Dummies - Equity Instruments - PDF

IN THIS CHAPTER »» Surveying socially responsible investing »» Investigating impact investing »» Checking out faith-based investing Chapter 7 Approaches to ESG Investing I n Part 1 of this book, you get a good understanding of why investing in ESG is an important consideration for your portfolio. Th...

IN THIS CHAPTER »» Surveying socially responsible investing »» Investigating impact investing »» Checking out faith-based investing Chapter 7 Approaches to ESG Investing I n Part 1 of this book, you get a good understanding of why investing in ESG is an important consideration for your portfolio. This part of the book focuses on the approaches to ESG investing that different investors may employ, and the types of instruments that they use to implement their strategy. This chapter, in particular, emphasizes that many terms have been used interchangeably to describe the incorporation of ethical, environmental, and social factors into investment fund management, such as ethical investment, green investment, and socially responsible investment. The definitions of these various terms all overlap, and many have particular significance for different industry participants. With the growth in investing in recent years, these industry terms have proliferated. However, distinct differences exist that influence how client portfolios should be structured as well as which investments meet social or environmental impact goals. CHAPTER 7 Approaches to ESG Investing 119 Understanding Socially Responsible Investing As outlined in Chapter 1, the integration of ESG factors is used to augment traditional financial analysis by recognizing potential risks and opportunities beyond technical valuations. While there is an overlay of social awareness, the main purpose of ESG valuation remains financial performance. Socially responsible investing (SRI) — the subject of this section — moves a step further than ESG by actively removing or choosing investments that correspond to particular ethical guidelines. The underlying motivation could be personal values, political ideology, or religious beliefs. Unlike ESG analysis, which influences valuations, SRI uses ESG factors to direct negative or positive screens on the investment universe. The definitions for SRI given by industry representatives include the following: »» The UK Social Investment Forum (SIF) defines SRI as an “investment which combines investors’ financial objectives with their commitment to social justice, economic development, peace or a healthy environment.” »» Eurosif defines SRI as an investment that “combines investors’ financial objectives with their concerns about social, environmental and ethical (SEE) issues.” Looking at reasons for SRI Regardless of the various definitions, there appear to be three common motives for SRI: »» To avoid investor participation in activities that they object to »» To inspire companies to improve their impact on society, the environment, or the economy »» To generate investment outperformance The first of these motives has historically provided the inspiration for SRI, but more recently, the other two factors have become increasingly important and are now the primary motivation for many SRI investors. Nevertheless, different SRI strategies are selected to respond to different investor motives, and each strategy could deliver a different result depending on the focus outcome, but traces of each motive are generally found in every strategy. 120 PART 2 Investing in ESG through Different Instruments Therefore, the key consideration is to view SRI as a long-term investment approach that integrates good ESG practices into the research, analysis, and selection process of securities within your investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors to identify companies with sustainable business goals (positive screening), while avoiding those with questionable practices (negative screening), in order to better capture long-term returns while benefiting society. Consequently, SRI promotes corporate practices other than profit maximization through capital investment. SRI strategies tend to follow the political and social dynamics of the time. This is an important factor for investors to recognize, because if a strategy is focused on a particular environmental, ethical, or social value, the investment may suffer if that particular value isn’t considered as relevant among investors in the future. Moreover, given that interest has grown in socially conscious investing, numerous funds and pooled investment vehicles are available to investors, including mutual funds and exchange-traded funds (ETFs), allowing exposure to multiple companies across many sectors with a single investment. However, investors need to read carefully through fund prospectuses to establish the precise philosophies that are employed by the fund managers, in order to ensure that they meet their own intended goals. It’s important to emphasize that there is a difference between SRI — which involves actively excluding or choosing investments based on explicit ethical guidelines — and impact investing, which looks to help an organization to complete a project or develop a program or do something positive to benefit society. (I cover impact investing later in the section “Evaluating Impact Investing.”) The main factors motivating SRI are primarily linked to investors’ desire to, for example, address climate change, the use of renewable energy, and water management, along with other environmental and social issues. Meanwhile, where exclusion screening persists — it’s still the most prominent strategy in terms of assets under management in Europe — tobacco is seen as the most popular exclusion criteria. Comparing a best-in-class strategy to an exclusion strategy One way to determine which companies may have the greatest positive impact is to adopt a best-in-class (BIC) strategy, which allows investors to choose those companies that have the best ESG scores in a particular industry sector. This also allows investors to choose a given criterion or target, and the final rating realized can be connected to the weighting of the criterion, which can depend on the sector. A BIC portfolio usually incorporates companies that meet both SRI/ESG and CHAPTER 7 Approaches to ESG Investing 121 conventional financial evaluations. However, some BIC portfolios don’t differ meaningfully from non-SRI portfolios, and so investors are increasingly searching for benchmarks or indexes that can be applied to implement a BIC approach. In short, getting best relative performance in terms of ESG scores doesn’t guarantee positive impact. The oldest SRI strategy is the exclusion strategy, which traditionally focused on the avoidance of “sin stocks,” such as companies concerned with the production or sale of alcohol, pornography, tobacco, and weapons. This approach systematically excludes companies, sectors, or countries from the acceptable investment universe when they are involved in activities that are considered questionable or unethical. This strategy can be applied at an individual fund or mandate level, but progressively even more so at an asset manager or owner level, across the entire product range of assets. However, some investors believe that for an exclusion strategy to be meaningful, it could be applied together with some attempt at engagement and stewardship policies, which implies that investors should hold symbolic amounts of stock in exclusion companies to be able to exercise voting rights. This allows active investors to show their commitment to creating a positive impact and better sustainability in portfolio companies. If they just sell the stock, the company may simply continue to operate in an unsustainable way that goes unchecked, which isn’t positive; however, they have to weigh any reputational risks that may be associated with continuing as an investor. Therefore, divestment may still be the best route with certain companies. Weighing the potential return on SRI decisions Some investors presume that integrating ESG factors into an SRI process will lead to lower returns, but there are growing indications that SRI could lead to greater returns. The principle is clear: The corporations that are most likely to operate effectively in the future are those with convincing social responsibility profiles, that trade in an objective and progressive way, with an executive team that tackles short-term risks while ensuring that the business is positioned to adjust to longterm transformational changes. Conversely, you shouldn’t expect that the returns from SRI indexes will be constant in the short term. There are likely to be short-term divergences in performance relative to the point in the economic cycle or market conditions. For example, SRI emerging market indexes have a fundamentally lower allocation to China than their non-SRI equivalents. This could cause return on investment (ROI) to diverge between these two indexes or portfolios if the Chinese equity market experiences strong gains or losses. 122 PART 2 Investing in ESG through Different Instruments In addition, there are concerns about the potential lack of diversity offered by ESG shares, given that many companies that meet the SRI criteria are predominantly large-cap stocks, which can limit the potential for diversification within investor portfolios. This could entail that investors find fewer opportunities within smallcap, mid-cap, and emerging market domiciled companies, while potentially excluding entire sectors, which enhances the risk of concentration within given sectors. The counterargument to this is that ESG incorporation into the SRI process allows investors to screen out companies engaged in unsustainable practices; this will exclude companies expected to underperform their competitors and result in a smaller but higher-quality investment universe. This suggests that any loss of portfolio efficiency will be more than offset by the more appealing investment characteristics of the remaining companies. Moreover, there are concerns over the ROI repercussions of limiting the universe of asset managers by excluding those that don’t observe a predetermined threshold of ESG integration. Many smaller asset managers have the ability to generate persistent alpha (in other words, consistently finding excess return in their portfolio) but haven’t fully incorporated sustainable investing strategies or integrated ESG factors into their processes. Meanwhile, larger traditional asset managers will increasingly integrate SRI principles into their investment process in order to boost returns. Nevertheless, there is a growing need to boost the supply of SRI investment proposals to meet the expected demand with more familiarization among finance professionals to engage successfully with clients when distributing information about SRI opportunities. Conversely, although fund fees have dropped in recent years, the fees for SRI strategies are naturally higher than passively managed funds as managers charge higher fees to counterbalance their need to monitor corporations’ activities to ensure that the criteria of the fund are being maintained. Higher fees can have a material effect on performance. Still, in general, the SRI momentum has influenced the adoption of responsible or impact investing strategies by several institutional investors, and numerous quasi-sovereign institutions have well-defined SRI policies: »» The Canadian Pension Plan completely integrates ESG into its investment decision-making approach. »» The Norwegian Sovereign Wealth Fund (Norges) deploys exclusionary screening and active corporate engagement to enhance the practices of its investee companies. »» Adoption in the United States has generally been slower than Europe; nonetheless, a notable exception is the Ford Foundation, which has pledged to invest US$1 billion of its endowment into mission-driven impact investments. CHAPTER 7 Approaches to ESG Investing 123 »» In his 2020 annual letter to company CEOs, BlackRock founder Larry Fink, as head of the largest asset management company in the world, publicly demanded that every company show how it makes a positive contribution to society. »» Morgan Stanley has created the Institute of Responsible Investing, which is tasked with integrating SRI strategies across all departments of their business. »» Many conventional asset management firms have launched impact investment funds, including Apollo, Bain Capital, KKR, TPG, and Wellington. However, investors need to differentiate between those strategies that they feel have been created as asset gathering tools versus those with a discernible track record of creating genuine impact. At the extreme, Chapter 6 covers issues around greenwashing and what needs to be monitored for that issue. Otherwise, undertaking some due diligence on the SRI or impact credentials of a fund can highlight what track record or experience it has in the field or whether it’s jumping on the bandwagon. Evaluating Impact Investing The demand for impact investing — covered in this section — has resulted from the continuation of substantial societal challenges (for example, demographic changes, inequality, social exclusion, and unsustainable development) and the failure of current institutions, such as governments, charities, non-governmental organizations (NGOs), and philanthropic organizations, to meet those challenges. Unlike SRI or ESG investing, impact investing isn’t just about sidestepping sin stocks or “doing no harm,” but also actively employing capital to tackle social and environmental objectives while creating financial returns for investors. It requires purpose, where portfolio companies must proactively track, measure, and report on their social and environmental impact. Where successful, impact investing is releasing significant capital from mainstream investors. Defining and tracking “impact” Despite the growing interest in such goals, more recently driven by the identification of the UN Sustainable Development Goals (SDGs; see Chapter 1), there is still no agreement on what impact investing specifically covers, which is reflected in the wildly different estimations in the size of assets under management from industry representatives such as the Global Impact Investing Network (GIIN) and the Global Sustainable Investment Alliance (GSIA). The SDGs are commonly 124 PART 2 Investing in ESG through Different Instruments highlighted as part of the impact frameworks that investors are creating, using them as a road map to help recognize where investment opportunities lie or how their current investment methodology aligns. They help investors communicate the contribution that they are making to provide solutions for the biggerpicture questions that society faces and to facilitate a unified stance for the industry. Impact investing is an approach to investing in initiatives, organizations, and funds that pursue the development of both financial returns and quantifiable social and environmental impact. Investors pursuing financial returns and impact refer to this as the “double bottom line,” borrowing an accounting term to convey how both facets need to be measured and reported. Impact investments are frequently made through closed-end private equity and venture capital funds, whereby debt funds have seen increasing popularity, more recently among impact investors. A number of traditional private equity firms have opened dedicated funds, introducing billions in new capital and pulling in institutional investors. Furthermore, this interest isn’t only coming from the “usual suspects,” such as foundations and health- or faith-based organizations, which have a natural disposition to consider impact. Mainstream institutional investors, including corporations and pension funds, are also showing real enthusiasm to be involved. In the UK, the private Social Impact Investment (SII) market peaked in 2019; however, the pandemic has hit activity in the SII market harder than the broader investment market, with a 25 percent drop in the number of announced deals completed in the UK in the first half of 2020, compared to the same period in the previous year. Nevertheless, greater activity is expected to rebound as impact investors look to support the economic recovery post-pandemic. The difficulty in tracking “impact” is an issue that still hampers the development of this market, as uncertainty remains with respect to precise definitions of positive impact. Such definitions vary as investors tend to track outcomes with their own distinctive metrics based on specific objectives, which may also vary at different parts of the investment cycle. Following are some of the measurement methods used to determine impact: »» Expected return method evaluates the estimated benefits against the projected costs to determine which investment yields the highest impact. »» Theory of change method outlines the projected process to realize social impact, using a tool that maps the connections between input, activities, output, outcomes, and ultimately impact (logic model). »» Mission alignment method measures the implementation of the project against its mission and end objectives over time, using scorecards to scrutinize and govern key performance metrics on finances, operational performance, organizational efficiency, and social value. CHAPTER 7 Approaches to ESG Investing 125 »» Experimental and quasi-experimental methods represent after-the-fact assessments that use randomized control trials to conclude the impact of an intermediation compared to the situation if the intermediation hadn’t taken place. Measuring social and environmental outcome targets Investing for return and impact is complicated, as many projects targeted at social and environmental challenges are relatively expensive without having immediate or explicit financial returns for investors; as a result, compromise is typically expected between returns and impacts. Consequently, international best practices and models for impact investing should be categorized and analyzed. Based on insights from past projects, sound methodologies can be created to facilitate identification of prospects that can produce measurable market rate financial returns and social and environmental impact. Practical lessons should also be drawn from past projects to determine how to fruitfully engage with optimal opportunities. For an impact evaluation, it’s difficult to categorize projects that are both realistic and measurable. Focusing on overly elaborate projects may be counterproductive as it may take many years and require a controlling stake in the entity in order to achieve meaningful impact. Therefore, rather than chasing multifaceted targets, it may be better to emphasize projects with a higher probability of success that can be achieved in a relatively short time frame. In addition, targeting impact goals that can be certified and audited by third-party entities and adhere to ISO (International Organization for Standardization) standards is important in the long run. (Examples can be found in this article: www.responsible-investor.com/articles/ the-world-s-official-standards-body-has-begun-writing-sustainablefinance-rules.) For impact investing to scale, products must be able to address the breadth of institutional requirements, comprising the capacity to absorb large pools of capital, and provide sufficient liquidity and stringent risk management practices, while producing measurable return and impact. These have usually been provided by investment strategies targeting blue-chip securities, primarily bonds. However, this results in directing funds to investments where it’s harder to proactively produce impact, as bondholders and minority shareholders have fewer opportunities to directly influence senior executives of large corporations. Moreover, bluechip securities are concentrated in mature markets, whereas the maximum need for impact capital is in emerging markets or less established areas. 126 PART 2 Investing in ESG through Different Instruments Conversely, research shows that specializing in fixed income does allow opportunities to scale up impact investments. In particular, a focus on emerging markets, servicing principally undercapitalized small and medium-sized enterprises (SMEs) in developing countries, highlights the opportunities in less efficient markets where better arbitrage opportunities may be found. Calculating impact metrics Although the commercial world has several universally acknowledged tools, such as the internal rate of return, for evaluating a potential investment’s financial yields, no equivalent exists for calculating social and environmental rewards in dollar terms. Projecting returns is often a matter of conjecture. For example, the reporting of ESG issues is now standard practice at the majority of large and midcap corporations, but this is usually restricted to information about commitments and process, and seldom scores actual impact. Impact investing has been described as the “third stage of responsible investment,” succeeding the stages of ESG integration and risk management. Nonetheless, the measurement of positive impact of products and services is still comparatively new, with methodologies and protocols still being established. There are a series of methodological challenges in the data, including concerns over the borderlines of corporate reporting and the capacity for “double-counting” of impact data, reporting over consistent time frames, and correctly evaluating or guesstimating product- and service-level impacts. Consequently, a number of obstacles need to be overcome first. Methodologies need to be standardized, and data quality and equivalence need to be substantiated, as more than 130 impact measurement initiatives need to be considered. While widespread research has been conducted in this area, the evaluation of impact normally incorporates a number of identifiable metrics that the investors consider to be applicable to the social or environmental issue being tackled. Both impact funds and traditional asset managers are initiating annual reports that monitor the development of such metrics during the life of the investment. One example of the research undertaken in this field is that conducted by the Impact Management Project, a collaborative, multi-stakeholder endeavor facilitated by Bridges Fund Management, an impact investment firm founded in 2002, and funded by such large institutional investors as BlackRock, Hermes Investment Management, and PGGM. They have considered five dimensions of impact: what, how much, who, contribution, and risk. Another example is the Harvard Business School Impact-Weighted Accounts Project, which aims to drive the creation of financial accounts that reflect a company’s financial, social, and environmental performance (visit www.hbs.edu/impact-weighted-accounts/). CHAPTER 7 Approaches to ESG Investing 127 In addition, NEF (the New Economics Foundation) has developed a framework based on cost-benefit analysis, social accounting, and social auditing, with the goal of capturing social value by transforming social objectives into financial and non-financial measures. Social return on investment (SROI) analysis is a process of understanding, measuring, and reporting on the social, environmental, and economic value that is being created by an organization. SROI measures the value of the benefits relative to the costs of achieving those benefits by creating a ratio between the net present value of benefits and the net present value of the investment. This provides a further framework for exploring an organization’s social impact, in which tangible monetization plays an important, but not exclusive, role. You can find information on how SROI could help organizations better understand and quantify their social, environmental, and economic value here: www. nefconsulting.com/our-services/evaluation-impact-assessment/proveand-improve-toolkits/sroi/. Focusing on Faith-Based Investing In many ways, faith-based investing — discussed in this section — was the original forerunner of socially responsible investing and subsequently impact investing. Therefore, the exponential increase in assets under management and a general interest in ESG principles and framework have naturally led to increasing awareness of faith-based strategies. Reviewing religious principles of finance Investors looking to invest in a manner coherent with Christian values frequently consider avoiding investing in companies that support non-Christian approaches — for example, from supporting abortion to building controversial weapons. Alternatively, they often favor firms that support human rights, environmental responsibility, and fair employment practices via the support of labor unions. The top three SDGs that faith-based investors seem to favor include decent work and economic growth (Goal 8), affordable and clean energy (Goal 7), and reduced inequalities (Goal 10). These SDGs also appear as top themes for impact investors in the GIIN’s flagship research report summarizing the largest industry survey of impact investors. The harmony between faith-based investors and impact investors’ concentrations in the same SDGs implies that there are opportunities for these entities to collaborate on common social and environmental goals. 128 PART 2 Investing in ESG through Different Instruments This is particularly true where impact investors can support faith-based investors in mobilizing more of their capital to realize positive, measurable, social, and environmental impact results. Multiple entities now provide assistance in investing in a manner that supports Christian values, and mutual fund firms and other funds are committed to such parameters for investors who don’t want to take the do-it-yourself approach. Indeed, faith-based investors are often ahead of the game when spotting potential alpha in certain trades because they are engaged earlier than other investors in issues such as climate change, where they consider the issue to be morally unacceptable. Before such investments appear on the radar of ESG investors as materially relevant, faith-based investors may have already excluded such entities from their portfolios or begun an engagement exercise. Meanwhile, investors specifically looking to pursue Islamic religious principles normally avoid so-called sin stocks, such as those issued by firms that profit from alcohol, pornography, or gambling, and investments in pork-related businesses are also prohibited. They are also forbidden from owning investments that pay rates of interest on their funds, or companies that receive a significant part of their revenue from interest payments. As an extension of this, many Islamic investors also try to avoid companies that carry heavy debt loans (and therefore pay considerable amounts of interest). Examining exclusion screening and divesting Faith-based investors from many faiths were at the vanguard of negative screening and divestment strategies, given that they were intentionally and publicly eradicating from their portfolios corporations whose practices were against their convictions. For example, in the 1970s and 1980s, such investors divested from Dow Chemical to protest against its production of Agent Orange, and from South African companies in response to their support of apartheid. Even more so today, considering the “no harm” principles of faith-based and ESG investors, portfolios are constructed to specifically exclude certain companies that produce goods or services considered to do social or environmental harm. These generally include sectors such as alcohol or tobacco, as mentioned in the previous section. Some large and well-known funds, such as the Norwegian Sovereign Wealth Fund, have their own exclusion list, which excludes firms engaged in “unacceptable greenhouse gas emissions,” due to their involvement in oil sands production, for example. CHAPTER 7 Approaches to ESG Investing 129 Moreover, when considering whether to include negative screening in an investment strategy (and which sectors or stocks need to be excluded), investors also need to determine the quantity of the portfolio that they are considering. Within a fund structure, this might only apply to the fund’s passive investments, or where they don’t have direct control. Alternatively, it might be related to all assets in the fund structure that require compliance of all the underlying active managers. Positive screening is a comparatively new, but progressively popular, investment approach that involves actively seeking values-aligned investments for your portfolio by using ESG ratings to identify best-in-class stocks. Negative screening is purely an exclusion process to remove unsuitable stocks, whereas positive screening allows investors to add stocks to their portfolio that are considered to be positively engaging with ESG factors. Advocating for values through proxy voting Shareholder advocacy calls for investors to use their voices as “part-owners” to influence demands for socially or environmentally responsible company policies and practices. Through discussion and meetings with company management, shareholders should directly support the adoption of good corporate governance and socially responsible approaches. Investors should also consider filing shareholder proposals that would be voted on at the company’s annual general meeting. Many faith-based investors are active participants in order to ensure promotion of corporate social responsibility. However, for those investors interested in bringing a company to task, there are minimum threshold levels that apply to ensure that a filing is submitted, which varies according to jurisdiction. The types of thresholds include a minimum monetary holding and/or percentage holding in the company or a minimum number of shareholders who support the proposal. The requirements to be met should be available on your local regulator’s website — for example, www.sec.gov/news/ press-release/2020-220. Investors should also actively vote on proposals submitted by management or other investors in advance of company annual meetings, or ensure that their proxy vote will be submitted by a delegate. Similar to exercising your democratic right to vote, investors should carefully review their annual proxy materials to consider how they should vote on given proposals. Historically, this has been something of a “rubber stamp” exercise to reinstate specific board members whose terms had elapsed, or to confirm the auditor company assuring the accounts. However, with increasing activism, those issues and others are being questioned. If you have concerns over the performance of a company, this is usually your main opportunity to make your voice heard, particularly with respect to topics such as executive pay. 130 PART 2 Investing in ESG through Different Instruments Central to ESG integration is engagement with the underlying asset managers to confirm that the managers are determined to improve their ESG integration practices over time, and also to ensure that the asset managers are engaging with underlying company management teams to influence their behavior in a way that is supportive of good corporate governance, environmental policies, and social practices. For further information, visit https://partners-cap.com/ publications/a-framework-for-responsible-investing. Alternatively, many large shareholders engage an external investment advisory service that, in addition to providing investment advice, will liaise with the thirdparty asset managers to scrutinize and foster adoption of policies in support of the investors’ desires for impact and ESG-related investing standards and engagement with company management. The primary advisory firms are Glass Lewis and ISS, but given that some firms play such an important role in shareholder voting, particularly in the United States, regulators have started to impose restrictions on some of their activities. CHAPTER 7 Approaches to ESG Investing 131 IN THIS CHAPTER »» Integrating ESG into stocks and other equity instruments »» Delving into quantitative strategies for stocks »» Checking out smart beta strategies for stocks »» Focusing attention on a given ESG theme Chapter 8 Analyzing Equity-Based Instruments T ypical equity-based investment funds are either actively managed (the ­portfolio manager decides where and what to invest in) or passively managed (a fund tends to follow market indexes, with no active decisions made by the portfolio manager). This approach applies equally to ESG funds: »» Some managers determine their ESG universe based on a given number of stocks, which naturally increases the active risk (the measure of risk in a portfolio that is due to active management decisions) within a portfolio. »» Other managers take a more passive approach by following a specified index and its composition of securities, some of which may exclude given stocks (for example, fossil fuels, tobacco, and arms-related stocks). In other words, the index company selects the portfolio of companies that the fund manager then follows. This chapter investigates how different equity-based strategies have been applied to the growing demand for ESG exposure. This ranges from how ESG factors are integrated into existing funds and strategies, including adjusting index-based or sector- and theme-based approaches, to how such factors are incorporated within smart beta or quantitative strategies. CHAPTER 8 Analyzing Equity-Based Instruments 133 Integrating ESG Strategies into Investment Decisions Awareness of the benefits of ESG integration is increasing, and the types of applications are growing. What do I mean by “ESG integration”? Glad you asked. ESG integration is the systematic and explicit inclusion of material ESG factors into investment research, analysis, and decision-making. This is one of three broad approaches to adding ESG analysis into investment decisions, along with screening and thematic investing (covered later in this chapter). All three ESG procedures can and often are applied simultaneously. The following sections run through the basics of getting started, discuss both active and passive investment approaches, and note where the respective ESG scores and risks can be recognized within given strategies. Just the basics: Getting an overview of the process Most investors will begin the process of ESG integration by following four common steps: 1. 2. 3. 4. Qualitative analysis: Collecting relevant intelligence from different sources, including company reports and research, and determining material factors that are influencing the company. When I say material factors, I mean financially material issues that are most likely to impact the financial condition of a company and are consequently most important to investors. Quantitative analysis: Measuring the effect of material financial factors on equities in existing portfolios or the wider universe, and modifying valuation models accordingly. Investment decisions: Using this analysis to decide whether to buy (or increase weighting), hold (or maintain weighting), or sell (or decrease weighting). Active ownership/stewardship: Using the prior analysis to inform company engagement and proxy voting decisions. This information can be used to support any future monitoring and investment analysis and to advise subsequent investment decisions. After this process, the evaluation of material issues from ESG factors can determine the following: 134 PART 2 Investing in ESG through Different Instruments »» Financial and financially material ESG factors »» The potential effect of material financial and ESG factors on company, sector, economic, and country performance »» Investment decisions to buy, hold, trim, or exit positions Adopting such an approach may involve changes to an investor’s processes, which requires a development of the skills needed to decide how ESG issues (covered in Chapters 3, 4, and 5) may impact individual company performance. Particularly, investors need to develop the skills to identify and integrate material ESG concerns, which are believed to affect company and investment performance. This can reduce the analysis required for those companies where ESG issues aren’t considered to be material at that time. Investors who are collecting ESG information from multiple sources — including company reports, filings, and ESG research providers — to identify the most material ESG issues per company or sector build this skill and experience over time. To achieve stock-level integration, investors will then commonly adjust financial statement forecasts and valuation discount rates in their financial models to reflect material ESG factors as well as any industry-related ESG issues. Given that companies can be scored using material ESG characteristics, portfolios can be constructed to overweight or underweight individual securities that match such characteristics in an optimized tilt. This balances the potentially opposing features of increasing a portfolio’s ESG score and decreasing the portfolio’s tracking error relative to its benchmark, thus permitting investors to integrate the ESG influence. Therefore, ESG indicators have been added to traditional financial measures, taxes, and other fundamental information to assess the value of public companies. However, many early-stage investors in ESG have primarily used simpler approaches, employing negative screening techniques, which effectively exclude certain types of stocks such as alcohol, tobacco, and fossil fuels. Alternatively, investors have expanded on this approach by focusing on given themes or sectors, either from an exclusion perspective, as per individual stocks, or from positive screening where they add stocks, sectors, or themes that exhibit positive ESG scores. (These approaches are covered in the later section “Constructing equity portfolios that integrate ESG factors.”) This has been particularly true in Europe, where the largest quantity of ESG-related assets under management reside. This is largely because companies haven’t traditionally reported or explicitly identified material ESG data that could affect their financial performance, so the only way to accomplish that is through investors proactively engaging with companies. CHAPTER 8 Analyzing Equity-Based Instruments 135 On a positive note, there are more industry-wide efforts to increase the standardization of ESG data and reporting requirements, which should greatly improve access to data. As standardization continues to improve, more institutional investors should follow the material ESG factor integration approach. This is already true for the United States, where ESG integration into analysis of listed equity investments is the most common ESG approach. However, greater integration in the United States isn’t due to U.S. companies reporting material ESG factors any better than elsewhere, so greater standardization of ESG data providers’ input is still required. Using active strategies The development of ESG investing is being driven by bottom-up pressure from asset owners and top-down policy initiatives. More investors are now concentrating on maximizing ESG performance through risk-return constraints, rather than the more traditional approach of prioritizing risk-adjusted returns. In other words, more investors are now focused on maximizing ESG performance, subject to their own risk-return limits, rather than purely focusing on an investment’s return subject to the degree of risk taken to achieve it (hedge funds and investors commonly refer to this as the Sharpe ratio). Market participants suggest that active managers have traditionally focused on issues that are most relevant to underlying investment performance through fundamental bottom-up approaches, and so they have the aptitude to explore and evaluate ESG issues that are financially material. Moreover, active management approaches have focused on shareholder engagement with management in a consistent manner. Active managers, due to their deep knowledge of companies, should play an important role in engaging with management on material ESG data points, providing a value-added proposition that could positively sway company behavior and push sustainable long-term value for investors. Because ESG issues are embedded with business issues, a single source of data isn’t always sufficient to decide on investment pros and cons. Many active ESG strategies will have a team of fundamental equity and credit research analysts, supported by expertise from an in-house ESG team, who assess material ESG themselves rather than relying solely on external ESG data providers. These multiple sources of data should provide greater flexibility and the capacity to concentrate on the most material issues relevant to the investment theme. Active ownership should also entail communicating with firms to enhance their ESG policies and practices. Engagement beyond formal data can be more meaningful than the data on its own, as the data providers each have a slightly different approach to evaluating ESG practices in companies. 136 PART 2 Investing in ESG through Different Instruments Moreover, ESG analysis is equally essential to active fundamental analysis. Issues that are material to performance are constantly evolving, and so investors’ approach to corporate engagement and analysis should also continue to evolve. Where analysts are directly engaged in the business context, procedures, and industrial requirements of a company and its sector, they should also be on top of ESG issues that are evolving, which provides confidence in measuring and establishing the credibility of the fundamental investment process. Furthermore, they should be able to attune allocations to reflect changes to ESG assessments as they arise. This ability to respond immediately to changing dynamics can allow active managers to unearth opportunities or risks that could be missed by passive ESG strategies, which may be more important in the current environment as corporations struggle to comply with changing disclosure regulations and investor expectations. Analyzing the impact of different ESG scores There’s an increasing body of evidence that corporations prioritizing ESG issues generate superior long-term performance across a variety of metrics, including sales growth, return on equity (ROE), and even alpha (a measure of market outperformance). Companies pursuing a stakeholder approach to value creation by integrating ESG into their long-term strategies are able to attract the best talent, develop loyal customer bases, benefit from sound corporate governance oversight, moderate risk, and push profitable growth by investing in sustainable innovations. So, shareholders should still benefit, but not at the expense of employees, customers, suppliers, or the community. Consequently, modeling a business around ESG factors can be an underappreciated source of sustainable competitive advantage, given the strong business fundamentals and ability to create market outperformance that such companies possess. Furthermore, this has been confirmed by testing the effect of material ESG scores on stock returns. Material ESG scores, which identify and evaluate only those issues that are financially important to a company, enhance forecasts of financial performance in comparison to total ESG scores. This finding has been particularly true for total ESG scores (an aggregate of the individual scores given to the ESG issues) as opposed to ESG score changes (the relative change in a total ESG score), which is in line with the long-term value-generation attribute of ESG performance: »» Total ESG scores are claimed to be a more accurate forecaster of longer-term business performance. »» ESG score changes are guided by short-term events and accordingly have a greater influence on short-term performance. CHAPTER 8 Analyzing Equity-Based Instruments 137 This analysis can be used to validate the view that long-term material ESG factors are currently mispriced by the market. So, by having a more qualitative incorporation of material ESG data in the valuation approach, investors could benefit from this mispricing. As long as such information isn’t transparently available, there is a competitive advantage for those analysts who can deliver such information, and given that the market has been slow to adapt, this mispricing may be available for some time. Moreover, if this information is combined with data provided in a business sustainability assessment questionnaire, they are even more significant as a forecaster of financial returns than broadly available public information, particularly for companies in industry sectors that exhibit more environmental risks. Watch out: Thinking about risks and disclosures Investment managers need to be able to measure and understand risk in order to manage it. Risk management is the essence of investment management, so analyzing ESG risk factors, alongside more traditional statistical and quantitative risk factors, helps deepen understanding of potential downside risks. Correspondingly, time invested now in evolving investment research to integrate an ESG framework will help differentiate the funds that will be successful in the future. In addition, analyzing more conventional quantitative-risk measures, such as tracking error or beta (the volatility of a security or portfolio in comparison to the market as a whole), alongside more qualitative ESG risk metrics ensures a multidimensional perspective. As the quality and availability of ESG data and analysis continue to evolve, asset managers who understand the data can use it to further inform their investment evaluation. ESG data should provide new perspectives to unearth any risks that are hidden in the balance sheets and financial ratios and identify new investment opportunities. In addition, the information offered by proprietary ESG scoring and ranking techniques has helped investors build a granular picture of corporations’ ESG performance. This has been driven by the increasing scope of mandatory ESG disclosure obligations. For example, under the EU’s Non-Financial Reporting Directive (introduced in January 2017 but currently being revised), listed EU companies with more than 500 employees need to disclose a range of information in their annual reports concerning employee, environmental, and social issues; respect for human rights; and corruption. Moreover, voluntary standards and frameworks, such as the Carbon Disclosure Project (CDP), the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), and the Science-Based Targets (SBT) initiative, are encouraging more standardized reporting that should lead to more informed ESG scores. 138 PART 2 Investing in ESG through Different Instruments Meanwhile, the Global Reporting Initiative (GRI; www.globalreporting.org/), the most widely used reporting standard, allows companies to determine which issues are material for reporting purposes, ultimately allowing investors to compare companies’ ESG performance and companies to incorporate guidelines into financial reporting. In addition, the Sustainability Accounting Standards Board (SASB; www.sasb.org/) takes an investor’s viewpoint to recognize which sustainability metrics are anticipated to have a material effect on the financial state or operating performance of companies. The definitions that SASB has determined as material per industry and sector have become reference points for many market participants. (Flip to Chapter 1 for more about the GRI and SASB.) Investigating how companies with higher ESG scores outperform Investors have traditionally been concerned that sustainable investing requires a risk/return trade-off when investing in corporations with strong ESG practices, an approach that provides lower risk but also lower return. This may have become more of an issue in recent years as more ESG-focused investment vehicles have been offered to investors and a record number of assets have been invested in ESG funds. Nevertheless, analysis suggests that in recent years, and during the COVID19 pandemic, ESG-based funds have performed well. One explanation for this could be that companies with high ESG scores have already succeeded in achieving better governance, lowering operational risk, and building in greater flexibility due to better employee relations and more reliable supply chains, and have thus minimized the risk to their business reputation. Consequently, they tend to be of higher quality, to exhibit lower volatility, and to be larger in market capitalization and more mature, with higher earnings and dividend yields. These factors have allowed them to protect their earnings better, and therefore to have gained wider acceptance than companies with lower ESG metrics. Conversely, a counter-explanation is that ESG funds’ outperformance can be better explained by what they don’t hold than what they do. Actively managed ESG funds have strict selection criteria, actively engage with companies in their portfolios, and avoid poorly rated ESG companies and sectors. Such funds are often underweight in, or exclude entirely, sectors such as airlines, tobacco manufacturers, and energy sourced from coal, oil, and gas, thus avoiding underperformance of those stocks in their overall return. Put more succinctly, generally speaking, buying “best-in-class” stocks and selling the “worst-in-class” should have generated an annualized excess return in recent years. Historically, this could have been explained away by cyclical rotation CHAPTER 8 Analyzing Equity-Based Instruments 139 in and out of given sectors in line with the cyclical performance of macro indicators. However, a paradigm shift seems to have been observed in recent years, initially driven by climate change concerns but exacerbated more recently by the impact of the pandemic. Further examination of the return drivers for different components within ESG shows that ‘E’ components (environmental; see Chapter 3) exhibit positive excess return by the outperformance of “best-in-class” stocks and underperformance of “worst-in-class” stocks. Alternatively, ‘S’ (social) and ‘G’ (governance) components appear to generate their positive excess return from the poor performance of “worst-in-class” stocks (see Chapters 4 and 5 for more about social and governance factors). Moreover, the ‘S’ component seems to have come to the fore in more recent years and is likely to receive even more attention after the pandemic. To compute ESG ratings requires a mixture of qualitative, quantitative, and engagement-based approaches by identifying material ESG risks and opportunities for each sector, allocating weights to the key indicators based on their materiality, and then combining quantitative ESG ratings with analysts’ financial recommendations. Take it easy: Applying passive strategies Two prominent investment developments in recent years have been the increase in assets that are passively managed and the growth in sustainable investing. Replicating both these developments, index-based funds that feature ESG factors have grown in both number and assets. While the majority of sustainably invested assets remain in actively managed ESG funds, net flows into passively managed ESG funds have outstripped net flows into active funds for four of the past five years. Investors have been drawn to passive strategies, such as passive index funds and exchange-traded funds (ETFs), in general due to their performance since the financial crisis in 2009 and the demand for lower-cost exposure to market beta. Meanwhile the shift to ESG indexes has seen responsible investing command an increasing share of the global ETF market, and this trend is likely to increase further. Index benchmarks are now being used by fund managers as tools to position investor selections and to redirect investment flows. The following sections go over the pros and cons of passive methods for integrating ESG into investment decisions. The pros Although many ESG investors use an active stock selection approach, passive (index-based) methods can also be well suited for ESG-driven portfolios. An index’s selection criteria for ESG issues can range across many different approaches, including ESG quality, sustainability, and thematic and sector 140 PART 2 Investing in ESG through Different Instruments exclusions. Passive strategies have democratized access to the financial markets at a low cost, characteristics that are consistent with an emphasis on passive ESG goals, and both approaches are data driven. Assuming that an appropriate index, either ESG or non-ESG, has been selected, asset managers can create one of the following routes to offering, for example, a passively managed ESG fund: »» Purchase an ESG index license, which provides the initial investment universe of constituent companies, and design a fund to replicate the index. »» Purchase an ESG index license and apply ESG methodology approaches, such as exclusionary screens, ESG integration and/or thematic filters (all covered in this chapter), to refine company selection and narrow the investment universe to a smaller set of companies based on defined rules. »» Weight the index constituents once they are selected. They can do this following index rules, such as by market capitalization, equal weighting, or “tilting” to underweight or overweight given companies based on specific rules. Given that passive investment funds are based on indexes, they share certain features that are appealing to investors who want to use their investments to contribute toward positive ESG impacts: »» They provide simplicity, as the indexes they are based on are transparent and rules-based, and are therefore easy to understand. »» As the underlying portfolio seeks to replicate the index, the companies in the portfolio will change as the constituents of the index are revised. »» They create performance benchmarks and help evaluate the broad perfor- mance of ESG and non-ESG universes. This generally requires less maintenance than for actively managed funds, so they tend to have lower fees and operating expenses. »» However, investors should note that the “low-cost” character of passive investing via ETFs and index funds is significantly different in the ESG framework. Net total expense ratios for passive funds and ETFs are generally higher than in the non-ESG universe, with passive ESG products levying a wide range of fees, the median expense ratio of equity ETFs being in the range of 40 to 50 basis points. Investment firms justify this additional expense through the need to perform additional due diligence or screening for ESG funds, but in practice they generally depend on ESG vendor ratings and third-party data. Nonetheless, market CHAPTER 8 Analyzing Equity-Based Instruments 141 acceptance of higher expense ratios reveals an acknowledgment of the due diligence requirements for ESG analysis. Passive managers tracking broad-based indexes can use ESG integration to overweight companies with better ESG scores and underweight peer companies. Furthermore, some passive managers deliberately differ from conventional benchmarks’ industry weights by excluding controversial companies, such as fossil fuel companies. The cons Critics of passively managed funds feel that ESG variations of those funds are just compounding the fact that conventional indexes, such as the S&P 500, don’t reflect the true economy, reward size, and liquidity, and take no account of, for example, corporate governance. Therefore, any funds with traits inherited from such indexes are inconsistent with the aim of moving toward genuine sustainability. Moreover, passive strategies are normally applied by utilizing a single third-party source for ESG research and data that rely heavily on voluntary company disclosure. This can create limitations in the quality, disclosure, and other biases inherent with ESG data, as this data is backward-looking, meaning that investors are missing a complete risk-reward analysis, which may result in skewed allocations to portfolio optimization and sector weighting. In addition, different third-party ESG rating providers often have contradictory views on the same company, which is difficult for the passive manager to understand as they are unaware of the source of the analysis, criteria, or assumptions made in giving a company a certain score in the first place. This is further exacerbated by the number of holdings in the chosen passive index, leading to a lack of in-depth understanding of the companies’ fundamentals and how the fund will be able to pursue active ownership strategies such as ensuring company engagement, filing shareholder resolutions, and developing proxy voting guidelines to ensure improvements in a company’s ESG policies and practices. Many observers are calling for greater commitment to improving corporate ESG practices from passive managers entering the sustainable investing space. Particularly with respect to proxy voting records, the largest index fund managers — BlackRock, Vanguard, and State Street, which together hold around 80 percent of indexed assets — have been criticized in the past for regularly voting in support of management and in opposition to ESG shareholder resolutions. Given the size of their holdings, their support is often vital in securing such shareholder resolutions. On the contrary, concerns aimed at index-like characteristics are less relevant to passive funds based on narrower thematic or industry-focused indexes, such as clean energy, where filters ensure that all companies in a fund contribute to the specific theme. Further examples of ESG issues addressed by sustainable investors 142 PART 2 Investing in ESG through Different Instruments include environmental issues, such as clean technology, water use and conservation, sustainable natural resources, and agriculture, while social issues include human rights, gender and racial equity, and workplace concerns. Also, rather than focusing on a way to determine ESG risks, a new generation of ESG benchmarks are being established to have a measurable impact, such as helping to meet climate transition goals under the Paris Agreement. Finally, while active managers are more concentrated on stock-picking portfolios, many institutional investors prefer to employ ESG investing through optimized benchmarking portfolios that fit their strategic asset allocation (SAA) policy. For example, they typically define an SAA portfolio based on market-capitalization indexes and observe their investments by computing any tracking error between the invested portfolio and the strategic portfolio. Therefore, they accept a maximum level of tracking error, prompting some managers to build ESG-based, optimized portfolios by minimizing the tracking error with respect to the cap-weighted index for a given ESG excess score. Effectively, this indexation with an ESG overlay approach offers investors a competitive solution to compete on price with traditional market-cap passive strategies. Consequently, ESG index tracker funds can offer a feasible, cost-effective solution for passive investors who, while mandatory holders of the index, are seeking a pragmatic solution to escape the unsustainable practices of many listed companies. Reviewing relative returns and performance of ESG stocks The general mantra from researchers and the market, based on more recent performance metrics, suggests that ESG investors don’t have to compromise on performance in order to pursue competitive market returns. Positive screening strategies based on ESG scores (whether created externally by ESG scoring providers or in-house by dedicated analysts) can raise the ESG quality of both passive and active traditional and smart beta portfolios, without reducing risk-adjusted returns. However, instead of focusing on maximizing financial performance from ESG criteria, many investors are now concentrating on maximizing ESG performance subject to risk-return constraints. Most market participants have reviewed the performance of ESG portfolios before and after the stock market sell-off caused by fears over the COVID-19 pandemic in 2020. During this period, the S&P 500 ESG Index, which tracks large U.S. companies with high ESG ratings, outperformed the established S&P index by 0.6 ­percent. Similarly, MSCI’s emerging markets ESG leaders index, and the more Asia-focused CHAPTER 8 Analyzing Equity-Based Instruments 143 AC Asia ESG leaders index, outperformed their parent indexes by 0.5 percent and 3.83 percent, respectively. Indeed, BlackRock calculated that 88 percent of a globally representative selection of sustainable indexes outperformed their nonsustainable peers over the same period. And this isn’t a new phenomenon as BlackRock has also suggested that similar outperformance was seen during market downturns from 2015 to 2016 and also in 2018. Of course, some investors may see the demand for ESG stocks with high ratings as a potential bubble, given the weight of funds that are deployed in those stocks. Could the current outperformance lead to overstretched valuations, which in turn may lead to long-term underperformance? This is causing some investors to analyze stocks where their current ESG ratings aren’t so high, but they are making credible efforts to improve their ratings through strong, sustainable business practices. The other regular explanation for ESG outperformance is that, through their exclusion or reduced weighting policies due to fossil fuel screens, most ESG funds have low exposure to fossil fuel assets, which has protected their portfolios when oil prices and energy stocks have fallen. Some analysts suggest that such factors account for only a small amount of any outperformance and propose that, apart from the momentum of investors’ buying supporting prices, better supply chain management and corporate governance have contributed to their effectiveness. To maintain high ESG ratings, corporations need to also maintain high levels of corporate disclosure for issues such as auditing of their supply chains, employee practices, and environmental stewardship. Often companies will use reporting frameworks such as the Global Reporting Initiative (GRI) or the Sustainability Accounting Standards Board (SASB; see Chapter 1 for details). This practice also helps businesses improve their own processes and benchmark their performance versus their peers. However, investors should be aware that ESG screening techniques can lead to increased exposure to large, profitable, and conservative companies, which may also result in increased exposure to certain industry, sector, or geographical biases. The bottom line is that there isn’t as much historical performance data for ESG funds as there is for the broader market; therefore, researchers are still building on conclusions drawn from sustainable investing data. This has been further complicated by changing classifications or definitions for what constitutes a sustainable investment strategy over time (the previous “sin stocks” exclusion focus may be more of a “fossil fuel” exclusion focus today), making evaluation and comparisons more difficult. This leaves plenty of room for researchers to develop algorithms that optimize the portfolio’s ESG profile while managing exposures to different risk factors within given limits. 144 PART 2 Investing in ESG through Different Instruments Verifying Quantitative Strategies The vast increase in the amount of material stock market data and the parallel increase in the amount of computing power available to analysts and researchers have enabled the development and growth of quantitative trading strategies. Similarly, as the availability of material ESG data has increased, there has been an increasing focus on quantitative strategies for ESG portfolios and stocks. As mentioned earlier in this chapter, quantitative approaches are one of the four common steps to consider when incorporating an ESG strategy and can be used in conjunction with integration, screening, or thematic strategies. One approach to quantitative investing is to help investors avoid the unintended risks of industry, sector, or geographical biases, mentioned earlier in this chapter, by targeting exposure to given risk factors. Such strategies target the intersection between companies that are efficiently managed, are profitable, and have strong cash flows while simultaneously exhibiting given ESG factors. To determine the ESG properties of targeted companies, quantitative strategies increasingly incorporate non-financial performance indicators that can be gathered from corporate sustainability reports or external ESG data providers using artificial intelligence (AI) techniques, such as Natural Language Processing (NLP). Moreover, quantitative managers who implement ESG integration construct models that incorporate ESG factors alongside other factors, such as growth, momentum, size, value, and volatility. ESG data and ratings are integrated into the investment procedure, which can result in the weights of individual stocks being adjusted upward or downward. Often investors have a limited understanding of the impact of incorporating ESG criteria into their portfolios, or to what extent the risk and return characteristics of the portfolios are modified, and style or factor tilts can develop as a result. Quantitative techniques are used to assess and control these results to allow investors to maintain their financial and sustainability targets. In addition, corporate ESG transparency is growing as the number of nonfinancial disclosure and reporting initiatives increase, such as the GRI and SASB (see Chapter 1), providing better data for quant techniques. A potential benefit of quantitative strategies is that there is no human judgment or discretionary buysell decision-making, as decisions are made by the model, which removes any predetermined biases, conscious or subconscious, from the investing process (although some would argue that there is an inherent bias in the way decisions are made when constructing the models). When dealing with emotive topics such as climate change or diversity and inclusion, natural biases can creep into the investment process. The growing body of research around ESG-based quantitative strategies suggests that ESG compliance and alpha generation aren’t mutually exclusive outcomes. CHAPTER 8 Analyzing Equity-Based Instruments 145 The following sections build on the principles of using quantitative approaches to identify the ways in which ESG factors are utilized. The quant approaches include constructing an equity portfolio, adjusting the weighting of particular indexes, and determining which ESG factors are considered more important. Constructing equity portfolios that integrate ESG factors ESG information identifies many risk factors that aren’t recognized through traditional financial metrics. Quantitative ESG analysts can scrape and scrutinize social media content to help update and allocate value to company intangibles. ESG intelligence should be reflected as a risk factor that doubles as an investment theme that has established correlations to returns, providing value to stocks with exposure to those factors. They can be included with conventional thematic factors, such as momentum, value, quality, growth, and volatility, and also offer diversification benefits because of their low correlation to traditional factors. Consequently, as ESG data becomes more established, statistically accurate, and comparable, more investors will use statistical techniques to pinpoint correlations between ESG factors and price movements that can create alpha or reduce material risk in their portfolio construction. Four key approaches are taken towards ESG portfolio construction: »» ESG integration: Investors increase or decrease the exposure to particular ESG factors by adjusting the weights of constituent companies based on the strength of material ESG issues or on their total ESG rating (also referred to as a “positive tilt” in favor of companies that fulfill certain sustainability criteria). This approach also incorporates investing in “best-in-class” companies with high ESG ratings or excluding “worst-in-class” companies with low ESG ratings. (ESG integration is covered earlier in this chapter.) »» Exclusionary screening: Investors simply exclude specific companies or sectors participating in activities considered unacceptable, unethical, or controversial. »» Exclusionary/inclusionary screening for thematic filters: Investors specifically exclude companies based on their exposure to particular industries (such as fossil fuels, arms manufacturers, gambling, and alcohol) or include companies (such as those focused on pollution prevention or that address one or more of the United Nations Sustainable Development Goals, covered in Chapter 1). 146 PART 2 Investing in ESG through Different Instruments »» Norms-based exclusions: This differs from regular exclusion policies in that it focuses on investors excluding companies on the basis of violation or non-compliance with international norms or standards of conduct as defined by the Organisation for Economic Co-operation and Development (OECD) or the United Nations, such as the UN Human Rights Declaration. From this starting point, managers can run different strategies — for example, performance based against relative returns (against a benchmark index) or total returns. Both strategies assume that certain elements of the stock markets realize stronger risk-adjusted returns than other segments over longer holding periods. Moreover, research indicates that financial markets are inefficient in determining material ESG scores and don’t necessarily price different levels of ESG performance well in the short term, and particularly not in the long term. Naturally, companies with higher ESG scores have a greater chance of being included in such portfolios, as many managers ensure that their portfolio’s ESG score is comparable to that of the benchmark index. Therefore, managers will positively screen stocks, as well as negatively screen them, for inclusion and exclusion strategies. Where managers don’t have their own internal ESG ratings, they will need to use data from a larger sample of ESG rating agencies to build a model that extracts the required information, or aggregate individual scores from specific rating agencies into one total score; this will help them to account for the differences in methodologies used by different providers. Research shows that a combination of alpha (a measure of the active return on an investment compared with a market index return) and ESG investment targets entails a higher active-risk acceptance from investors. Given the percentage of assets under management that are predicted to be linked to ESG factors in the future, investors and managers may need to review whether current market benchmarks (standard market capitalization–weighted indexes) are appropriate benchmarks given their sustainability and risk/return objectives. Investors should also be aware of the appropriate time horizon for ESG integration in their portfolio construction: »» Highly active portfolio managers that build focused stock portfolios with comparatively high turnover (generating higher costs) may concentrate on isolating and mitigating short-term event risks. As a result, they will be more concerned with potential ESG issues that occur more frequently. »» Portfolio managers constructing broad, diversified portfolios with long-term investment horizons, such as indexed or buy-and-hold investors, need to focus on these long-term risks in their choice of ESG criteria and integration, mitigating event risks through diversification. CHAPTER 8 Analyzing Equity-Based Instruments 147 Moreover, it has been found that companies with high ESG ratings outperform companies with low ESG ratings, and they also show a lower incidence of stockspecific events, leading to lower levels of systematic risk. Adjusting stock index constituent weights The objective of any of the many ESG indexes available from index providers is to help investors measure the performance of ESG-aligned portfolios. They are often designed to provide risk/return characteristics that are similar to the underlying universe, while offering the additional benefits of enhanced index-level ESG performance. For example: »» Some of these indexes will use different methodologies to modify company weights based on the index providers’ ESG ratings, thereby allowing industryneutral re-weighting to ensure that the industry weights in each index match the underlying benchmark universe. »» Other indexes may focus on the stocks with the highest ESG scores, combined with the equally weighted performance of the largest stocks, by market capitalization, within specific regions. However, ultimately investors need to consider the ESG issues that are material for investment performance, and whether broader ESG indicators provide value relative to specific data on given ESG factors. Incorporating ESG “momentum,” by buying companies showing improved ESG ratings, has improved performance relative to concentrating on the ESG rating itself. In addition, combining ESG scores with traditional financial metrics has produced more positive results than using ESG data on a stand-alone basis. Nonetheless, ESG-based stock selection can introduce size, sector, or geographic biases relative to standard index-based exposure. This problem can be further exacerbated by the methodology used for ESG ratings by the index provider. Different approaches can lead to markedly different ESG scores for individual companies, which can naturally result in different index constituents or weighting per ESG index for given sectors or geographies. Determining which ESG factors matter most in quantitative strategies Research studies from financial institutions such as Amundi and MSCI highlight that not all ESG data is “fit for purpose” when looking for ESG trends and performance: 148 PART 2 Investing in ESG through Different Instruments »» The most relevant data for interpreting risks and returns comes from ESG ratings based on industry-specific financially material scores. It’s also clear that different ESG issues can be material for different industries, which is supported by the SASB’s approach to corporate disclosure, where industryspecific indicators are required. »» ESG issues don’t necessarily impact all stocks, with a disproportionate effect on “best-in-class” and “worst-in-class” companies in the market. In addition, increasing investor demand for ESG exposure has created more investment in “best-in-class” stocks, which naturally lifts stock prices and performance in those names, while exclusion policies for “worst-in-class” stocks lead to falling prices and underperformance in those entities. »» The research highlights that time (the holding period), size (the investment universe), and scope (of the investment strategy) are three additional factors that investors must consider when gauging what impact ESG screening has on returns, volatility, and drawdown for their portfolios. Given that different ESG issues are material for different industries, these issues can be selected and weighted for each of the Global Industry Classification Standard (GICS) sub-industries based on potential exposure to the corresponding issue. The most commonly utilized issues that are considered when calculating a company’s ESG rating are as follows: »» Environmental (‘E’ segment): Carbon emissions, water scarcity, toxic emissions, and waste (see Chapter 3) »» Social (‘S’ segment): Labor management, health and safety, human-capital management, and privacy and data security (see Chapter 4) »» Governance (‘G’ segment): Corporate governance, business ethics, corruption and instability, and anticompetitive practices (see Chapter 5) When considering which of these ESG segments has the greatest impact, it’s important to remember that some key issues are interrelated and can be focused on capturing risks related to events, such as fraud or an oil spill, which tend to affect companies’ stock price in the short term. Meanwhile, other key issues focus on long-term risks that can erode a company’s stock price over longer periods, such as carbon emissions. Of course, some key issues can also show features of both short- and long-term risk. Environmental issues tend to suffer more from long-term risks that play out over time. Social issues show a mix of short- and long-term risk characteristics, and governance issues have the highest short-term risk profile due to the greater propensity for event risk. In deciding how to apply this information, active portfolio managers may want to focus on mitigating short-term event risks, depending on CHAPTER 8 Analyzing Equity-Based Instruments 149 how actively they trade and what their time horizon is. Conversely, portfolio managers who are building diversified portfolios with long investment horizons may be more focused on long-term erosion risks. The distinct differences across the ‘E,’ ‘S,’ and ‘G’ pillars are summarized in the following sections. Environmental issues The three key environmental issues — carbon emissions, water scarcity, and toxic emissions — are driven by long-term risks, with individual company performance showing positive long-term differences between the “best-in-class” and “worst-in-class” scoring companies. There are generally insignificant differences in the tendency for event risks between such companies. Social issues The key social issues show differing results, with labor management (including labor conflicts) showing both strong event risk and long-term risk features; however, this was far less prevalent for best-in-class scoring companies. Health and safety showed similar traits for the benefits of best-in-class, but there is negligible distinction between high- and low-scoring companies on event risk. Despite some high-profile cases, differences in companies’ management of privacy and data security haven’t historically contributed to positive performance, and high-scoring companies haven’t avoided more negative events than lowscoring companies. Governance issues Governance-related issues generally show the strongest results from both risk perspectives. However, business ethics and anti-competitive practices show much stronger event-risk characteristics with negligible long-term risk. Low-scoring companies on business ethics are far more likely to experience a severe stockprice loss than top-scoring companies, while the differences are much less noticeable for corruption issues. However, corporate governance, particularly with respect to corruption issues, shows greater long-term risk characteristics and less event-driven risk differentiation. In general, companies with strong corporate governance exhibit much better profitability and lower stock-specific and systemic risk than low-scoring companies for key governance issues. 150 PART 2 Investing in ESG through Different Instruments Putting it all together Within individual key issues, carbon emissions (‘E’ segment) show the most meaningful outperformance of all key issues, with health and safety as well as labor management (both ‘S’ segment) and corruption (‘G’ segment) representing the next-most important issues. These “top-performing” key issues indicate that long-term risks are more evenly distributed across the ESG segments than event risks, which tend to be more concentrated in the ‘G’ segment. This explains why governance issues have consistently shown the strongest significance for stockprice risks over shorter periods of time. Having identified the key ESG issues within each component, it’s important to consider how individual factors are aggregated within a portfolio. Assuming an investor has selected stocks with different ESG issues and weighted them for given sectors or industry classifications, thereby making up an overall ESG composite score or rating, this approach can make a significant difference to financial performance over time. Combining the ‘E,’ ‘S,’ and ‘G’ components together in a random way will be less effective than taking a dynamic approach to adjusting by industry-relevant issues, materiality, and appropriate weightings on a predetermined basis. This should allow investors to integrate relevant ESG factors in a way that captures emerging risks and opportunities. Identifying Smart Beta Strategies Two of the most significant trends in the global asset management industry have been the growth in ESG investment and smart beta strategies. Smart beta can be defined as a rules-based investment strategy that sits between active management and conventional passive management (market cap–weighted). Therefore, smart beta can be seen as an overlay strategy to the approaches mentioned earlier in this chapter to build ESG portfolios, in that smart beta strategies typically capture specific factor exposures. The growth of smart beta strategies has been driven by a mixture of low costs and returns potential, with the promise that they typically cost less than actively managed funds but offer outperformance compared to traditional passive products. The relative significance of both smart beta and ESG has increased considerably in recent years, and further growth is anticipated as investors combine these strategies. Some market commentators suggest that passive strategies, including both smart beta and market cap–weighted approaches, will reach an estimated 25 percent of global assets under management by 2025. CHAPTER 8 Analyzing Equity-Based Instruments 151 Currently, smart beta ESG isn’t a mainstream offering, but research suggests that adoption rates are increasing, even more so in Europe than the United States and Asia, with larger investors currently more active than smaller investors. Three broad approaches for combining smart beta and ESG have been identified: »» Extending negative screening, such as excluding companies involved in tobacco or controversial weapons, to smart beta strategies. This straightforward approach is also the most popular and can be achieved through mandates, dedicated funds, or internally managed portfolios. »» Using ESG metrics, which are calculated through internal quantitative testing (covered earlier in this chapter). Many investors use this approach to add financial value to traditional factor strategies to improve the risk/return performance of their internal smart beta indexes. »» Blending ESG information and smart beta strategies. A smaller number of investors follow this approach, using portfolio tilts based on specific ESG metrics, such as climate change. Some barriers to these approaches continue to be an insufficiently long track record of ESG data and disclosure, while others feel that continuing developments in Machine Learning (ML) could identify relevant correlations between ESG performance and stock returns, which could increase the inclusion of smart beta ESG strategies in the future. Combining ESG data with recognized risk premia factors (the amount by which return on a risky asset is expected to outperform the return on a risk-free asset) is a valuable development in the smart beta industry, with some investors viewing ESG as an established factor on its own. Moreover, a significant amount of research, testing, and planning has been made into smart beta ESG, which is likely to materialize in the near future. Investors appreciate the clarity that rules-based smart beta brings to ESG integration, giving a clearer view of which ESG inputs are being used and facilitating targeted ESG exposures. Others feel that ESG metrics are more insightful than overall scores in an ESG integration context and that the quantitative focus of smart beta is expected to help create higher-quality ESG data over time. Conversely, incorporating ESG information into smart beta strategies could potentially lead to factor bias, as some investors have found ESG to be negatively correlated to value stocks and positively correlated with quality. In addition, some investors feel that active management (discussed earlier in this chapter) offers a better platform for engagement, due to the greater concentration of portfolios and the fact that active managers have more flexibility than smart beta managers to make tactical portfolio changes in response to new ESG information, such as event risk. 152 PART 2 Investing in ESG through Different Instruments The following sections outline how ESG factors can be incorporated into smart beta and portfolio construction approaches to more explicitly avoid unwanted exposures or achieve specific weightings in their portfolio. Extending negative stock screening to smart beta strategies ESG scores can be used to exclude “bad” stocks from a portfolio, which leads to improved scores for standard passive portfolios, without worsening their riskadjusted performance; however, they can also improve smart beta strategies even further. One approach is to extend negative screens, by excluding companies involved in tobacco or controversial weapons, to smart beta strategies. This is normally realized through mandates, dedicated funds, or internally managed portfolios. Some investors may focus their screening on specific ESG issues, such as carbon-related measures, to highlight a company’s carbon intensity relative to its industry peers. This approach is taken by the majority of smart beta strategies. Alternatively, other investors use ESG metrics that they have discovered through quantitative testing to add financial value to traditional factor strategies. For example, by developing ESG factors around issues such as corporate environmental, carbon, or governance data, it’s possible to improve the risk/return performance of existing, internal smart beta indexes. Using ESG equity factors and scores to weight portfolio construction Institutional investors who want to integrate ESG factors into their investment strategies require the right tools to evaluate portfolio risk features and performance. In addition, the composition of an ESG portfolio hangs on the investor’s objectives. The reason for an ESG investment may be driven by ethical factors, such as social activism, and financial considerations, such as alpha generation or index tracking. This varied set of objectives leads to a detailed set of technical conditions that enable portfolio construction. The subsequent technical specification relies on the quality of the material ESG data, as well as the investor’s level of risk aversion and comfort level with stocks that are correlated with agreed exclusions and underweights. In any portfolio, unwanted exposures or underperformance relative to a benchmark are feasible; however, the developing library of ESG data and the expansion of portfolio construction techniques continue to allow investors to hold the components that align with their ethical and financial views. CHAPTER 8 Analyzing Equity-Based Instruments 153 Most investors want to build optimized portfolios with enhanced ESG scoring, while keeping risk, performance, country, industry, and style attributes similar to their established benchmarks. In addition, expected improvements in ESG scoring allow investors to go beyond traditional exclusion-focused strategies. Supporters believe that markets don’t price ESG factors efficiently because they address longterm risks that haven’t been understood by the economy, and so alpha generation is possible as markets begin to recognize these undervalued effects. Therefore, overweighting companies whose ESG scores are improving — benefiting from ESG momentum — or underweighting companies with lower ESG scores are two ways of improving portfolio performance. However, it’s important to identify systematic sources of return from common market factor contributions, relative to asset-specific returns that benefit from material ESG factors, while maintaining acceptable levels of tracking error from the established benchmark. Research suggests that the market penalizes companies with lower ESG scores more than it rewards companies with higher ESG scores. This may be due to investors’ views that poor ESG practices are sources of risk, forcing them to price in ESG risks more quickly based on events (pollution, fraud, and so on) than to incorporate long-term upside of ESG opportunities into stock prices. The lower ESG ratings anticipate event-driven news that threatens stock returns more than they recognize higher ESG ratings reflecting material and long-term upside, offering discounted values in such stocks. Focusing on a Given Theme Investors can get exposure to many ESG investment themes in their portfolios. These largely focus on environmental or social themes such as renewable energy or health and well-being, and they tend to address a given investor’s values, where they want explicit exposure to a theme. Sector exposure can be considered an implicit approach to a similar goal by investing in given sectors that address those themes rather than specific companies. Sector exposure ESG investment funds are often skewed toward industries, such as pharmaceutical and technology stocks, but are underweight on sectors, such as airlines or energy. These sector biases, largely driven by ESG rankings or exclusions, have insulated ESG funds against any downturn in recent years and driven a performance boost for most. 154 PART 2 Investing in ESG through Different Instruments The Global Industry Classification Standard (GICS) has 11 sectors and 158 subindustries. Of these 158 sub-industries, only about 100 find their way into portfolios composed of the top 30 percent of ESG-scored companies. Therefore, industries’ weights in a portfolio roughly align with associated industry ESG scores. Moreover, the five industries with the largest weights have higher ESG scores, and the five industries with either minimal or no exposure have lower ESG scores. As a result, sector and industry selection has helped ESG funds outperform the main benchmark indexes in recent years. It’s currently unclear how much year-to-year proactive sector rotation takes place within ESG portfolios; therefore, industry “tilts” may cause a long-term bias that ESG portfolio managers should be aware of, and they should adjust sector or industry selection, or associated weightings, as necessary. Sector or sub-industry performance can also vary from year to year, but the principal way for sector weights in ESG portfolios to change is for businesses from different sectors to increase their ESG ratings and become integrated or to move down and drop out. In addition, some industries don’t have companies rated by ESG scoring vendors, so those industries are ineligible for inclusion in an ESG portfolio. Where a manager feels that a portfolio’s sector weights need to be adjusted, they may consider executing an active sector overlay strategy to enhance the existing portfolio. Thematic exposure Investment themes linked to the Sustainable Development Goals (SDGs; see ­Chapter 1) have become more prominent on investors’ sustainability road maps as they attempt to create positive impact while capturing opportunities in the global equity market. The SDGs have provided central pillars in forming the sustainability approach of many investors, governments, and civil society groups. The new decade has begun, leaving just ten years to achieve the SDGs by 2030. However, recent progress reports issued by the European Union (EU) and the United Nations suggest that most of the 17 SDGs are unlikely to be met on time. Nonetheless, the SDGs capture many of the more exciting upside opportunities in today’s equity markets and are closely linked with global economic growth and overall macroeconomic health. Of these, five key ESG themes stand out: clean, efficient energy; environmental protection; sustainable infrastructure and development; health and well-being; and social equity. In addition, improved data and analytics for ESG investing creates an opportunity for investors to better manage risk and performance around SDGs. CHAPTER 8 Analyzing Equity-Based Instruments 155 The focus on SDGs has prompted the emergence of thematic fund launches in areas such as clean water, renewable energy, and social housing. However, the transition from fossil fuels to renewable energy, for example, will impact countries, industries, and sectors beyond fossil fuel exporters and the energy sector. Entire industries and sectors that aren’t making the transition to a low-carbon future face possible downgrades, while research estimates that a quarter of the value of global equity and fixed markets is tied to the fossil fuel value chain. About 20 percent of global carbon emissions were covered by some sort of carbon tax in 2019, which is likely to grow to more than 50 percent as close to 100 ­countries are enacting new regulations. In addition, the Principles for Responsible Investment (PRI) warns that up to US$2.3 trillion of company valuation could be lost by 2025 because of government policies to tackle climate change, including support for renewable energy and bans on coal and carbon prices. Increasingly, investors want fossil-fuel-free portfolios, and the call to fund climate-change solutions through their investments is growing. Meanwhile, companies will face higher fuel costs, updated building codes, and clean-energy requirements, so new strategies to support companies with products and services that support a lower carbon transition are prevalent. Resource shortages are becoming more of a focus with, for example, a variety of sectors being heavily dependent on access to water resources, such as utilities, apparel, and agriculture. Companies with operations in dry locations are particularly exposed to these risks, and developed countries aren’t immune from these issues. Estimates suggest that nearly half of the rivers and lakes in the United States may not meet the needs of people in the next 50 years because of aging infrastructure, population growth, and lower annual rainfall. Investors are monitoring how well companies are managing water shortages and embracing efficient solutions, while funds dedicated to supporting water regeneration are cropping up. 156 PART 2 Investing in ESG through Different Instruments IN THIS CHAPTER »» Creating a plan to develop a policy »» Participating in a peer review »» Reviewing your core investment principles »» Getting familiar with ESG-specific standards »» Checking out reporting requirements »» Starting ESG engagement Chapter 13 Devising an ESG Policy A sset owners are the economic owners of assets and include pension plans, insurance companies, official institutions, banks, foundations, endowments, family offices, and individual investors, each of which has different investment objectives and constraints. Asset owners can invest in an asset either by purchasing that asset directly or by hiring an asset manager to invest on their behalf. When an asset owner utilizes the investment management services of an asset manager, such investments can be structured as separate accounts or commingled investment vehicles (for example, mutual funds). Asset owners make critical decisions about how their money is invested, including the following: »» Establishing investment policies (for example, investment objectives, asset allocation policies, and approaches to sustainability or ESG matters) »» Whether to manage their assets internally or outsource to an external asset manager »» How to handle their responsibilities as public company shareholders (for example, proxy voting policies, reliance on proxy advisors, and insourcing versus outsourcing of investment stewardship activities) CHAPTER 13 Devising an ESG Policy 233 This chapter looks at devising an ESG approach for an asset owner. Many corporations have adopted a purpose statement, which normally refers to their mission, primary goals, and core beliefs. Even though such statements are often communicated at a high level, the idea that they outline a longer-term horizon that they aspire to is comparable to the longer-term objectives needed for an ESG policy. Here’s a Great Idea: Creating a Plan Any document that is developed to show the intent of an organization in a given direction should start with a plan that establishes the short-term and long-term objectives of the company that need to be implemented in order to meet the ­organization’s ultimate ESG aspirations. This could begin with an analysis of the organization’s current approach and systems, which could be mapped to the overall objectives in order to identify obvious, initial gaps. This approach could be guided by interim targets for review, and tasks and frameworks set to enable implementation in a coordinated fashion. Some investors can struggle to communicate their approach, particularly smaller organizations that are new to the process. An initial approach taken by some is to refer to frameworks such as the UN Sustainable Development Goals (SDGs; see Chapter 1) and Principles for Responsible Investment (PRI) to help inform ­discussions and identify goals that map to the core high-level beliefs central to an organization. (Visit www.un.org/sustainabledevelopment/sustainabledevelopment-goals/ and www.unpri.org/download?ac=4336 for more information.) This can be combined with a statement of priorities that further defines any essential sustainable themes, in ESG terms, and that also enables mapping to potential investment opportunities. Clearly, some priorities may not be immediately investable, but confirmation of these requirements helps ensure that investors proactively investigate potential paths for investment in the future. Additional approaches to inform the process should include an internal review process, wider stakeholder consultation, and potentially the engagement of an external service provider. It’s important that the methodology employed be inclusive to ensure representation of all relevant and material assessments. Furthermore, it’s necessary to recognize that without well-defined core principles, the work of the trustee (who is responsible for ensuring that the assets are managed properly and that owners’ benefits are secure) and other fiduciary and regulatory requirements will be difficult to forcefully implement. As the plan begins to unfold, milestones should be present to ensure monitoring and evaluation of progress are in place to observe the organization’s development against the originally planned objectives. In addition, ownership of the policy and 234 PART 3 Applying ESG Philosophy results should be held by management at the highest level possible to ensure that cultural fit and organizational governance “buy-in” is maintained. The following sections outline some of the key considerations to develop an ESG framework. It’s important to involve all stakeholders and agree on an internal governance structure, some of which can be gleaned from a peer asset owner review, before determining the core investment strategy. Promoting ESG among key stakeholders The stak