These global challenges we face mean that the relationships between companies and their stakeholders – including employees, consumers, suppliers, governments, and the environment – have never been more complex or critical to understand.
The current backdrop has given impetus to a much broader interest in the adoption of sustainable investment and ESG, which is fast becoming one of the most important strategic priorities for investors.
Here, we outline the four key steps needed on the road ahead to sustainable investing.
Emphasising fundamental, proprietary research – de-emphasising external ESG ratings
The industry’s reliance on ESG ratings from external research providers has arguably distorted efforts for further integration of ESG analysis. We recognise that ESG ratings offer a way for investors to systematically compare a large number of securities, flag sources of potential ESG risk, and benchmark portfolios but as standalone measures, they have inherent limitations.
A host of challenges will need to be solved when it comes to interpreting ESG data, including:
1. Variation and inconsistency in disclosure
Disparity in handling missing data (imputation techniques) and benchmarking techniques used by third-party ESG research and data analytics companies.
A lack of contextualisation of ESG issues whose materiality can vary depending on the sector, region, or complete idiosyncrasies.
The latter point can best be addressed by undertaking deeper proprietary and fundamental analysis to determine how a company’s management of its human and natural capital link to its financial productivity as well as the potential for valuations to be impacted by changing demand patterns for its products and services, as part of the transition to a more sustainable world.
2. Integrated analysis by investment professionals not separate ESG research teams
Asset managers’ tendency to have ESG research teams work in silo from their investment teams has also hampered further integration.
As the industry increasingly recognises the shortcomings of the current ESG data landscape and external ESG ratings and research, we anticipate an increased need for asset managers to evidence how ESG research is genuinely integrated into their investment process. They will also need to show how it contributes to better investment outcomes, via risk mitigation or alpha generation.
We think that ESG research and analysis needs to be undertaken by one and the same analysts that covers the industry and underlying companies. We like to think that if ESG analysis is to impact investment decision-making then ESG must be part of everybody’s job and not something delegated to a separate research team.
3. PMs taking the lead on stewardship
We believe that fundamental research and active engagement are both crucial to impactful ownership. This requires investors to engage regularly with company managements and their boards, vote their proxies, and incorporate findings from their stewardship activities back into their financial models and investment decision-making.
While historically most asset managers have separated their stewardship activities from their investment processes, we believe that this will no longer suffice.
Engagements and proxy voting decisions should be undertaken in consultation with, and led by investment decision-makers. This ensures that conversations with company management takes place by those individuals that own the shares in their portfolios on behalf of end clients. We believe this is the best way to ensure the learnings from engagement feedback into investment decisions to ensure better outcomes for clients and their beneficiaries.
4. Increased use of alternative datasets and analytical tools
Investors are increasingly seeking newer, more sophisticated alternative datasets and analytical tools to provide forward-looking views on environmental and social considerations.
Our research has proven the need for access to more robust alternative datasets and the need to develop analytical tools that can interpret and manipulate complex data. Fundamental analysts who have a deep understanding of the sectors and regions in which their companies operate add value by being able to contextualise this data and interpret its relevance for the industry.
What will it take to succeed?
The industry increasingly recognises that incorporating material ESG considerations into analysis provides a more comprehensive assessment of investment risks and opportunities that can help lead to better investment outcomes for our clients.
Rapid changes in the attitudes of consumers, citizens and policymakers on issues like single-use plastics, thermal coal and diversity illustrate that it is impossible to invest over the long-term without thinking about the materiality of these issues and how they might impact the investment case for a company.
Despite decades of evolution, the opportunity of truly investing sustainably is yet to be fully realised. Complex global issues, including climate change, racial, gender and social inequality, and political polarisation, will continue to present investors with significant challenges as well as opportunities.
Jennifer Anderson, co-head of sustainable investment and ESG and Nikita Singhal, co-head of sustainable investment and ESG, at Lazard Asset Management