How to Integrate ESG Considerations into Investments
A lot is said about the materiality of environment, social, and governance (ESG) issues in investment decision making. Examples of these issues include air and water pollution, biodiversity, climate change, customer satisfaction, employee attraction and retention, product misselling, separation of chairman and CEO, bribery and corruption, executive remuneration, and so on. It is hard to argue that these issues are not material — but how do you actually integrate these ESG considerations into investment decision making in practice?
To answer this question, we interviewed Jeroen Bos, CFA, who is the head of Global Equity Research at ING Investment Management and member of the board of directors of the CFA Society Netherlands. In recent years, Bos has been working on improving the integration of ESG factors in ING IM’s equity research process with a clear goal to improve the risk-return profile of the equity investments they make.
CFA Institute: Please explain what is meant by integrating ESG considerations into investment decision making?
Bos: The importance of responsible investing (RI) has increased substantially in recent years, and one of the key aspects of RI is the integration of ESG factors in the investment process. What we mean by this is that, in addition to reviewing the financial data of a company, we should also include an analysis of intangible factors and “softer” items that relate to how a company deals with its environment, how it addresses its labor force and supply chain (i.e., social items), and how aligned the management team is with outside shareholders (i.e., governance).
These ESG factors can have an important impact on investment performance, and hence not including a proper analysis of these ESG factors actually results in an incomplete assessment of the potential investment and therefore could even lead to incorrect investment decisions being made.
In the past, ESG analysis was often done through a screening process, mainly to filter out certain investments from an ethical perspective (tobacco, gambling, human rights violations, etc). Often this analysis was done by a separate ESG team that simply provided this overlay to the “mainstream” analyst’s research process. For example, a buy rating from a mainstream analyst could be marked down to a neutral or sell rating, or even be excluded from the investment universe, due to a very poor ESG score. More recently we see ESG analysis moving from focusing on exclusions to increasingly laying focus on the companies that score well on ESG factors and have positive ESG momentum, i.e., companies that are improving how they score on ESG factors.
If ESG issues are indeed material, why are they not integrated into the investment process to begin with?
That’s a great question. I think that in the past some of the ESG factors have been, or should have been, already integrated in, e.g., the strengths, weaknesses, opportunities, and threats (SWOT) analysis. However, this was often done in not a very structured and systematic way.
One of the reasons that responsible investing took years to be accepted is the misperception that investing in a responsible way would actually reduce the investable universe and therefore would have a negative impact on investment performance, reducing return or increasing risk. RI was seen as being too “green” and/or “ethical,” and implementing it would hurt performance. Furthermore, some claim this would therefore also be in violation with the asset manager’s fiduciary duty to maximize investment returns.
Many studies have been done in this field in recent years. It is fair to say that, at least, integrating ESG factors improves the downside protection while potentially improving the upside. In any case it improves the risk/reward characteristics of an investment portfolio. Other studies have also shown positive correlation between ESG score improvements and performance. One study I like a lot is one on the relationship between employee satisfaction (i.e., related to the S in ESG) and share price performance. This study, published by Alex Edmans in 2011, shows that the higher the employee satisfaction, the better the stock returns. An additional interesting outcome from this study is that this effect has also increased in the last decade, in my view likely on the back of human capital becoming more important in today’s world. Another study I like is one by Derwall, Bauer, Guenster and Koedijk, that shows that the best environmental responsible companies outperform the least environmentally responsible firms.
In the end that all makes perfect sense, as the goal of investing in a responsible way is to look for sustainable business models, models that often result in having a competitive edge and enabling the company to achieve better returns. Longer-term this should lead to superior investment performance from a risk/reward standpoint hence is perfectly in line with an asset manager’s fiduciary duties as well. Furthermore, integrating ESG factors can, and should, also be seen as simply being a more complete approach to investing. This gradual realization is now leading to an increasing focus on the analysis of ESG factors in the overall investment process.
Give us an example of ESG integration in equities, how it works in practice.
At ING Investment Management the mainstream analysts integrate ESG factors in a detailed and structured way when they look at (potential) investments. We use ESG data from third-party vendors including Sustainalytics and GMI Ratings which give us a good and efficient first view on how a company scores on a variety of ESG factors, including governance, related party transactions, alignment of performance targets, environmental impact, human rights issues, fraud, and/or tax evasion to name just a few. This data gives the analyst a good starting point to further review the company’s situation, and it helps the analyst to form a clear opinion, an opinion he should incorporate both in his valuation and recommendation.
To give you an example, a few months ago one of our analysts did a detailed analysis on one of the large pharmaceutical companies, and the ESG part of the analysis clearly indicated issues in the area of governance, related party transactions, tax evasion, and bribery. The analyst’s view was that these issues are very likely to continue to negatively impact the business and would have an ongoing negative impact on the share price. Therefore, we actually decided not to recommend investing in the stock.
Still, it is important to note that this does not mean we will not invest in that particular stock in the future. We will continue our engagement with this company’s management team and keep track of any potential progress in this area.
Once an investment decision maker has ESG research ratings of different potential companies/investment he is considering, what are his options in constructing a portfolio?
From a portfolio construction perspective, portfolio managers can take into account ESG factors in several ways. When implementing analyst’s recommendations, ESG factors should, in my view, already be part of this recommendation (or at least this is the case at our firm), and this leads to a decision to overweight or underweight a stock in the portfolio, taking into account the context of that specific portfolio as well, of course. Note that this decision is not only driven by the ESG score but driven by the overall analysis which includes ESG factors. In case a PM is benchmark agnostic, it will be more of a buy or not-to-buy decision instead of an over-underweight decision, while hedge funds can even include the option to go short certain stocks.
In addition, firms can have a list of potential exclusions that prohibits PMs from investing in certain stocks (like Law Mahoux exclusions in certain parts of Europe).
On a portfolio level, a PM can also track the average ESG score of his/her portfolio (potential vs. a benchmark) and optimize risk/reward in this respect. Lastly, I feel it is important for both PMs and analysts to be actively engaged with companies on topics that relate to ESG, which, in the longer-term, can further contribute to portfolio performance.
Is there sufficient and timely ESG disclosure available to investment decision makers?
Although this has been improving in the last few years, there is still a lot of room for improvement. Companies can still improve reporting, and we see initiatives such as the GRI (Global Reporting Initiative) and the IIRC (International Integrated Reporting Council) helping to push this further. In addition, third party providers like Sustainalytics, GMI Ratings, and MSCI are expanding their coverage, as well, and providing more and more data on ESG factors to support us in making our investment decisions.
It’s a little bit a chicken-and-egg problem in that for the companies to start disclosing more, investors need to show more interest in these ESG factors, and investors (at least partly) often show more interest in cases in which there is data to work with (i.e., being disclosed by the companies). That’s why we believe that engagement with companies to discuss the important ESG topics is also very important and will also gradually push companies to disclose more.
What organizational arrangements in investment management companies are being commonly used for integrating ESG considerations?
The way to integrate ESG factors in one’s investment process has also been gradually evolving. Traditionally, analyzing ESG factors was often not fully included, or was external to, the investment process. In our view a proper analysis should always include a view on ESG factors, as by not including material ESG items one will likely make an incomplete assessment of the fair value of a company. Key when integrating ESG factors into an investment analysis is to focus on materiality, i.e., factors that are likely to have a material impact on the (longer-term) sustainability of a company’s business model and its share price performance. Examples include: safety standards, shareholder engagement, and environmental impact in the mining industry; labor issues and food safety in the consumer sector; product liability and bribery in the healthcare sector; and governance and alignment between management and shareholders in general. On top of that, asset managers/owners could decide to bring in stricter measures, also including nonmaterial factors, that provide protection against reputational risk or reflect their values and beliefs.
Some investment managers have started to employ ESG specialists that provide an ESG overlay to the investment process. At ING IM we have actually taken the next step and have made incorporating ESG factors an integral part of our investment process done by the “mainstream” analysts and portfolio managers. I strongly believe that this is the way forward and that the industry will gradually move into this direction in the coming decade.
Where do we stand today and how do you see the outlook on integrating ESG considerations in investment?
I believe that we are still in the early stages of ESG integration, and I strongly believe that the focus on investing in a responsible way will increase in the coming years. As the ultimate client of the investment industry, society is driving the increasing focus on sustainability and responsibility. Asset owners/managers will also increasingly focus on managing their reputation, something that has grown in importance due to the emergence of social media. Furthermore, investing in a responsible way and integrating ESG factors in the investment process can also be used to reflect ones values and beliefs, which I feel is also increasingly important, in particular for large investors like pension funds. All these drivers, in combination with more evidence that integrating ESG factors in the investment process can actually improve the risk/reward of investment portfolios, should drive this practice into the mainstream of investing in the coming decade. Although just an indication, note that the assets under management by PRI signatories (Principles for Responsible Investments) have shown a 35% CAGR in the 2007–2012 period, illustrating the momentum.
Overall, I believe that the increased importance of responsible investing and ESG integration brings clear opportunities to the asset managers and investment professionals who embrace this trend.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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