A growing body of research supports a positive relationship between high ESG characteristics and improved investment outcomes. As an investment factor, however, ESG continues to lack uniform definitions and a solid methodological baseline for security analysis. For example, there are no generally accepted accounting principles for ESG.
A bottom-up ESG integration approach that is investment-led and focused on materiality is optimal. Such an approach can increase portfolio diversification and maximise the integration of both ESG quality and alpha-related inputs.
Devising a practical and structured plan that can be implemented across a business for a successful ESG integration strategy is paramount. This is one such plan:
1. Be flexible and investment-led
ESG factors can be integrated in multiple ways. An ESG integration framework should therefore be flexible and align with the particulars of a given investment strategy. For example, ESG teams should provide investment teams with the right tools, training and in-house ESG expertise to implement an integrated approach, or allowing investment teams to tailor the ESG integration process according to asset class, style, time horizon etc.
2. Build strong partnerships with fundamental analysts
The number of ESG specialists aside, systematic ESG integration cannot be achieved unless fundamental analysts and ESG specialists work together. Financial and ESG information must be considered concurrently.
3. Focus on industry and macro-economic context
Identifying ESG issues should consider, and be corroborated by, the macro-economic context and any relevant industry-specific competitive forces. ESG materiality should be assessed at the macro and sector levels first, then the issuer level in order to determine whether those very issues could result in risks to a company’s market valuation or fundamental profile.
4. Identify downside risk and upside potential
Although many investors think of ESG primarily as a risk input, it can also represent upside opportunities. Therefore, analysts should focus on both the ability of the issuer to manage potential costs and/or liabilities and capture growth opportunities flowing from ESG issues. It is also important to consider time horizon, as exposure to an ESG risk or opportunity may not materialise for five, 10, or even 15 years.
5. Achieve an equilibrium between ESG quality and returns; avoid unintentional biases
As ESG demand grows, investors should be aware of the potential risk of a crowded ESG trade. Once a good ESG trade becomes public, its success may attract other investors, eventually leading to concentration and overpricing. Thus, investors should redouble efforts to be creative in unearthing ESG rising stars.
6. Remain data intensive while considering variant ESG views
Investment teams should consider third-party ESG ratings and artificial intelligence and understand the drivers underpinning these opinions and signals. However, they should do so while generating variant views to exploit any potential disconnects.
7. Build your own ESG framework
The financial materiality of ESG analysis should be supported by proprietary research based on combined ESG and financial variables with a focus on investment implications. Proprietary ESG assessments should also apply to various asset classes and be dynamic, capturing whether an issuer’s risk management practices are improving or worsening over time.
8. Embrace long-term stewardship
Engage with issuers that have weaker ESG performance relative to their peers but show room for improvement. This helps portfolio managers to not only gain a more thorough understanding of the company’s approach to ESG risk management, including controversies and remedial actions, but also encourage management to improve.
9. Take a solutions-driven approach
There is no one-size-fits-all approach to ESG. As client needs and regulatory developments continue to evolve, so should the capabilities of investment managers.
10. Be passionate
Any new enterprise, regardless of the field, requires passion to succeed. The millennial generation has fully embraced, with passion, the importance of ESG issues. They are likely to expect genuine passion on the part of their asset managers as they seek investment solutions in an effort to secure their long-term financial viability.
The investment community’s conceptual understanding of ESG and its role in investment decision-making is continually unfolding. Accounting for ESG risks and opportunities is in line with fiduciary duty – it is not disconnected from financial returns, but to successfully achieve this alignment, investors must take an investment-led approach focused on materiality and fundamental analysis.
Guillaume Mascotto, head of ESG and investment stewardship, American Century Investments