It’s as Simple as E-S-G

 

April 18, 2019 [ACTIVE MANAGEMENT, BETTER WORLD INTERNATIONAL, ESG]
Di Zhou, CFA, FRM and Jim Gassman

 

 


Sometimes a well-established approach is better when it comes to “good” investing.

There is a wide variety of ESG investment approaches, so it’s no wonder that investors who are searching for an ESG strategy find themselves bewildered. Sometimes ignoring the noise and choosing an ESG strategy that takes a traditionally active, bottom-up approach provides the clarity investors need.

The Wild West
An ESG strategy often incorporates a business’s environmental (E), social (S) and governance (G) track record in its investment decision. However, including ESG criteria in the investment process can sometimes be complicated.

First, managers vary in the ESG criteria they use and how they apply it. For example, one manager might focus on executive pay when assessing a company’s governance record while another might emphasize ownership and control. Consequently, it’s sometimes difficult for investors to discern which criteria is better at driving ESG outcomes. Second, ESG data provided by companies vary greatly in terms of the quantity, quality and correlation to ESG criteria. Finally, there are ESG ratings agencies that provide tools that seek easier ways to compare ESG performance across companies. However, they also use different scoring methodologies and weightings, which often leads to very different ratings for the same company. With all of these issues to consider, ESG investing can seem more like the Wild West than a structured way to invest with a purpose.

The sheriff has arrived
Taking an active, bottom-up approach to ESG investing can help cut through the complexity and improve outcomes. An active manager that integrates bottom-up, fundamental stock analysis with ESG criteria has the ability to pinpoint investments that can produce ESG outcomes and drive long-term profitability.

An experienced active manager can focus on those measures that have proven to be highly correlated to ESG outcomes. For example, a firm may tout its recycling program as evidence of its strong environmental record. However, fundamental research may uncover that the firm’s carbon footprint is three times larger than that of its peers, which works against an isolated recycling program in its benefit to the environment.

Data roundup
Active ESG strategies that conduct rigorous research and independent analysis can discern when company data may seem impressive but don’t really show evidence of actual ESG performance.

An active manager also can weigh the ESG criteria that is appropriate to the industry. For instance, when comparing environmental records, water conservation should be more heavily weighted for a large beverage company versus an internet startup, which uses far less water in its operations. Similarly, where a beverage company is located makes a difference as well since water scarcity varies by geography.

Finally, while some investment strategies might not consider investing in a company with a less-than-perfect ESG rating, some active managers can go a step further. They can uncover if that firm is improving its ESG practices or is actually producing positive ESG outcomes but may not have the resources to report their positive results. Either could lead to a compelling ESG investment that others might miss.

In short, applying the familiar, understandable approach of bottom-up, fundamental investing to ESG can be effective in generating outcomes that investors seek without the confusion that newfangled, more complex ESG approaches risk creating.


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