Practical analysis for investment professionals
20 January 2021

ESG Research: Solving the Integration Challenges

The advent of the Joseph Biden administration will likely create a significant tailwind for environmental, social, and governance (ESG) fund products in the United States and accelerate their already torrid growth.

Under the outgoing Donald Trump administration, the Department of Labor (DOL) amended the Employee Retirement Income Security Act (ERISA) to specifically prohibit pension trustees from considering ESG factors in selecting investments and managers despite objections from many industry participants.

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The new administration will probably reverse this prohibition in short order, opening the door for a potential proliferation of new ESG products introduced through the 401(k) channel and in the segregated mandate market.

US managers have been slower to board the ESG bandwagon relative to their European peers. How can they catch up?

Active managers have seen significant growth in the ESG investing segment, especially in equity and fixed-income funds. To access this growth, asset managers will be pressured to show that their commitment to ESG integration goes beyond superficial lip service. They will need to demonstrate that they have fully incorporated ESG principles into their investment processes.

“Greenwashing” accusations have risen alongside the rapid growth of the ESG category. Some funds labeled as “ESG” are only nominally incorporating these considerations. In Europe, regulators have responded, imposing ESG reporting requirements starting in 2021 in an attempt to ensure that the labels are accurate.

Tile for The Future of Sustainability in Investment Management

In the United States, the SEC has not made detailed reporting as big a priority. But investors themselves, particularly institutional asset owners and consultants, will want proof that the ESG label is more than just a “wrapper.”

This is a key challenge for asset managers. In many cases, ESG teams have worked in relative isolation, separate from the traditional fundamental investment teams. They must support multiple products, both specialist ESG funds focusing on climate change, clean energy, etc., and as an overlay for non-specialist funds. Integrating ESG principles into the latter category may require traditional fundamental investors to embrace new analytical frameworks.

ESG research tools are also more varied and nuanced than the research inputs of traditional strategies. They include databases, research from both investment banks and independent research producers, proxy advisers, sentiment trackers, web-scrapers, and all manner of specialists that reflect the range of activities and objectives contained in the United Nations (UN)’s 17 Sustainable Development Goals (SDGs):


UN Sustainable Development Goals (SDGs)

Illustration of UN Social Development Goals (SDGs)

Given the broad spectrum these SDGs cover, every aspiring ESG fund asset manager must decide where they will focus and what ESG implementation strategies they will employ and to what proportion.


ESG Implementation Strategies


The first ESG funds were primarily exclusionary in nature. They avoided companies associated with tobacco production, arms manufacturing, carbon energy, etc. But ESG has evolved to include more nuanced approaches, including investing in firms that are taking active steps to meet these SDGs and to engage with company management.

Consequently, how asset managers demonstrate ESG integration research in their overall investment processes will be a function of the ESG strategy choices they have made. The following diagram distills those choices:


Diagram of hypothetical company's integration of ESG factors

Part of the integration process should address how and to what degree various funds are using ESG research inputs. In the longer-term, the distinction between ESG and non-ESG funds will blur.

ESG research inputs are particularly difficult to value because of the variety of ESG approaches and implementation strategies that managers use and because important ESG research inputs—databases, for example—do not lend themselves to document or interaction counting.

This raises three key questions:

  1. How can managers value ESG research inputs given the manager’s particular ESG process; input diversity (data / documents, etc.); and at the fund or client level?
  2. How can managers demonstrate ESG integration in their wider research process to clients and other stakeholders?
  3. How can managers determine whether incremental ESG research spending should be internal or external?

What is required is an ESG research valuation process that can overlay the manager’s existing research valuation methodology so that the ESG research inputs can be valued based on the manager’s ESG product and implementation approaches. That process should also demonstrate how those approaches are applied across all of the manager’s funds.

This can then be augmented by benchmarking research spending.

Managers that can demonstrate this to asset owners and consultants will be well positioned to capture the growth opportunity that ESG offers.

Further insights on ESG integration are available at FrostConsulting.

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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.

Image credit: ©Getty Images / Gabriel Shakour

About the Author(s)
Neil Scarth

Neil Scarth is a Principal of Frost Consulting, which works with asset managers and asset owners on a variety of research issues including research valuation/budgeting software platforms (FrostRB), strategy-level research spending database/benchmarks (FrostDB), and investment process ESG ratings. He has held a wide range of roles in asset management and investment banking in both Europe and North America, ranging from running equities businesses at global banks to launching and managing all aspects of varying asset management products. He has also published on related topics with CFA Institute, Stanford University, and the University of Edinburgh.

5 thoughts on “ESG Research: Solving the Integration Challenges”

  1. Robert Jones says:

    This is the sort of virtue signaling crap that has caused thousands of CFA members to drop the designation. ESG is politics and has no place here. If CFA Institute is incapable of separating political opinion from fiduciary duty, clients would do well to hold the political designation against members. It is unprofessional to force your political views on others.

  2. Tom Marthaler says:

    I have always admired the CFA society for keeping members up to date on innovation and trends that impact our industry. Change is inevitable and it’s our responsibility to understand market dynamics. ESG is here to stay and many investors have embraced this strategy. The goal remains the same – we must understand our clients investment objectives and then build a portfolio to achieve their goals.

    1. Robert Jones says:

      This really depends on one’s clientele. If you serve trust fund babies, who inherited their money — they did not earn it themselves— then paying lip service to their latest temper tantrum is part of your job. Being a nanny might be the majority of your job. Taking care of infants is exhausting, and you have my sympathies.

      For the other 99.5% of the population, this ESG virtue signaling is crap. Most people are struggling to save enough for retirement and can little afford to invest in politics.

      In practice (not in rhetoric) ESG fund holdings are remarkably similar to active fund holdings … and for similar reasons tend to underperform index solutions.

      Like active funds, the high fees of ESG are good for advisors — and after following those spoiled brats around all day you probably deserve extra compensation… for the nanny work, not the investment.

  3. Mr. Scarth has drawn attention to on an important and challenging issue in Responsible Investment: important because analysts who fail to integrate material ESG issues into their valuation process may handicap their performance; and challenging because, while the ESG data sources may be inchoate, the ESG integration process is … well, at the end of the day it’s just traditional financial analysis with some additional inputs, and therefore hard to label as anything other than ‘active management’.

    The UN backed Principles for Responsible Investment (PRI) mandates two practices for Responsible Investment: first, the integration of material ESG issues into the valuation and selection of securities; and second, active ownership of portfolio securities, in particular engagement with management and the considered voting of proxies on ESG issues. The two practices should combine to help active managers improve risk adjusted returns, though – as Mr. Jones comments – the perennial challenge to active managers remains: the improved performance must outweigh the cost of the new ESG data and active ownership.

    The PRI’s definition of Responsible Investment is entirely consistent with the Body of Knowledge covered in the CFA program, and while CFA Institute has partnered with the PRI for several years, the incorporation of material ESG issues into the CFA program has until recently appeared to lag, and the ‘active ownership’ side of the equation still lags. (Ownership has generally been considered through the lens of a ‘control premium’ and not one of ‘shareholder engagement’.)

    The challenge to CFA Institute and others is that ESG issues are still identified with the morals-based Socially Responsible Investment (SRI) movement that in turn traces its roots to the screening of ‘sin stocks’ by religious organizations. As Mr. Scarth notes, there is ample literature tracing the evolution of SRI screening (see for example Viviers and Eccles (2012); Schueth (2003); or Domini (1992)). Despite the PRI’s clear practitioner-oriented definition it is SRI’s morals-based approach that is most often associated with ‘ESG investing’ by the general public, and most visibly by fossil fuel divestiture movements on university campuses. Unfortunately, ESG has become a catch-all phrase that updates and replaces SRI.

    SRI is clearly a behavioural rather than neoclassical finance approach, and while many investors may quietly align their morals with their stock holdings, it is not hard to find examples of the ‘virtue signalling’ that Mr. Jones decries and that is at odds with Modern Portfolio Theory.

    As Mr. Jones also comments, the active and passive managers of Wall Street have seldom shied from opportunity – in this case the opportunity to exploit ESG issues that are both material to investment performance and that resonate with investors’ morals. The ESG issues will align to produce positive alpha in some periods and negative alpha in others, but they will always be available for marketing campaigns and the gathering of assets (and perhaps for annual letters to CEOs).

    One of the reasons so many asset managers have signed on to the PRI may be to signal to institutional asset owners their ESG bona fides without needing to espouse a particular (or any) screening approach. The PRI requires an annual filing detailing a signatory’s ESG practices, and while Mr. Scarth notes the challenges in his type of reporting he then falls down a rabbit hole by failing to distinguish between the incorporation of material ESG issues into analysis, and the use of ESG issues for a morals-based investment screen.

    Mr. Scarth appears to burrow a bit further when he states that “every aspiring ESG fund asset manager must decide where they will focus and what ESG implementation strategies they will employ and to what proportion”. His wording implies a thematic approach that aligns fund holdings with SDG outcomes, which may align with morals-based marketing campaigns, but which renders secondary issues that most analysts would consider of primary importance: the financial materiality of issues under a framework such as that promulgated by the Sustainable Accounting Standards Board (SASB). (To be fair to Mr. Scarth, his comment does align with the direction the EU appears to be headed with its recent ESG taxonomy work, but my comment would also apply there).

    To paraphrase Meir Statman’s recent work, there is nothing wrong with aligning one’s morals with one’s investments – indeed, as Mr. Marthaler comments, it is often part of an advisor’s job – but it mixes two separate goals: optimizing risk-adjusted returns; and feeling good (or at least not feeling bad).

    Despite these quibbles with Mr. Scarth’s article, he does raise an important point. At the end of the day, the integration of material ESG issues into the analysis and valuation of stocks should be a routine part of an analyst’s job (and a central part of the CFA program), but it is difficult to assess managers’ approaches ex ante. If CFA Institute appeared a bit slow on ESG issues, perhaps it is because the analytical tools remain the same – just the ESG issues and inputs are new. For their part, active managers should consider ESG issues as a potential source of alpha, and as an additional cost to be managed.

    For a good, high level overview of reporting and impact measurement challenges for ESG issues please see Jennifer Howard-Grenville’s January 22, 2021 article in Harvard Business Review.

  4. Robert Jones says:

    Ian Robertson wrote: “ The UN backed Principles for Responsible Investment (PRI) mandates two practices for…”

    As long as we are talking ethics, let’s try to be more honest in comments. The UN is a non-government political organization. It is a political organization known for taking ethical shortcuts whenever it is politically expedient to do so.

    It is also deceptive to use the word “mandates” here. The UN has zero legal or moral authority. It is not a government. It’s member countries, including all G7 countries, have voluntarily abided by or ignored UN opinions as it suited them.

    The UN is not a religious organization either, and lacks moral authority. It has placed countries known for torture on its human rights committee.

    The UN is a ***POLITICAL*** organization, and Mr Robertson essentially, if unwittingly, strengthens my point that ESG is political.

    No amount of virtue signaling or Harvard references can change a simple underlying truth: it is unethical to force your political opinions onto others. Taking advantage of the self guilt many trust fund babies have isn’t very noble either.

    The ESG political movement is itself unethical and tyrannical.

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