Q&A with Author of the PRI’s Practical Guide to ESG Integration for Equity Investing
On 6 September, the UN Principles for Responsible Investment (PRI) launched A Practical Guide to ESG Integration for Equity Investing at its annual PRI In Person conference. The agenda of this year’s conference was designed to promote a regional understanding of responsible investing as a risk management tool and alpha generator. Among the speakers is Paul Smith, CFA, president and CEO of CFA Institute, serving on a panel discussing investing for the long term from the perspective of institutional investors.
We expect the new report to become an important resource to investors around the world. As we saw in the ESG survey conducted by CFA Institute about a year ago, more and more people are integrating ESG factors into the investment process, but many people are still looking for guidance on “how” to integrate ESG factors in the investment process.
We talked to Justin Sloggett, senior manager of Investment Practices at PRI and the author of the report, to get a better sense of the report itself, how it came about, and how it can be used as a resource by investors and analysts.
What was behind the decision to draft this report?
The PRI published its first report on ESG integration in 2013 — Integrated Analysis — which includes 21 case studies by leading practitioners. Despite the release of the report, our signatories/members are still asking the PRI about how to integrate ESG factors into investment analysis and decisions.
So, the PRI decided to release a second report on ESG integration — A Practical Guide to ESG Integration for Equity Investing — to provide further in-depth guidance and new case studies (51 in total) that illustrate advanced integration practices.
Does the report cover ESG integration across geography and asset classes?
The report is intended to provide guidance to our signatories/members around the globe. The PRI has a number of committees that represent the geographic spread of our signatories/members that advise on projects and publications, including this publication. Although it is true that the level of ESG integration varies across financial markets and asset classes, the guidance in the report can be applied by all investors because the integration techniques discussed are applicable to existing investment analysis and models.
The focus of this report is on listed equity. The Investment Practices team at the PRI produces guides that focus on individual asset classes. In addition to the two listed equity guides, the PRI has ESG integration guides on fixed income and private equity. By the end of 2017, the plan is to have two reports on ESG integration in hedge fund strategies.
Tell us a little about the structure of the report and what you want to highlight.
What became apparent at the beginning of this project was that there was a need for the new report to have a broader scope than the Integrated Analysis report, which focused purely on integrating ESG factors into active fundamental strategies. The new publication consists of the following chapters:
- Integration Techniques: There is a significant amount of interest in understanding the integration practices in all investment strategies. So, we included guidance and case studies on ESG integration in fundamental strategies, quant strategies, smart beta strategies, and passive strategies.
- Sell-Side Research: The goal of this chapter is to understand what research is being done by sell-side brokers. We were pleasantly surprised by the number of research pieces contributed to our study. This chapter maps out the different types of ESG-integrated research available to the buy-side in an attempt to promote more ESG-integrated research. So, it does require the sell-side to allocate more resources in this area while the buy-side needs to clearly demonstrate a need for this type of research.
- Assessing External Managers: Responsible investment and ESG integration are important to our members. Asset owners with externally managed assets are very active in assessing external managers on their integration practices because they rely on them to integrate ESG considerations into their assets. But finding managers that practice ESG integration is difficult. So, we examined the manager selection and monitoring process, with input from 16 prominent asset owners, to identify the areas in which asset owners can assess managers on their integration practices, and then we created sample questions that asset owners can use to assess their external investment managers.
- Impact on Investment Process: Creating an ESG-integrated investment process does not happen overnight. It is an endless process that can take years to develop. This chapter provides some insights on ESG-integrated investment processes and includes best practice case studies on components of investment processes of leading practitioners.
Case studies in the report are broken down into fundamental strategies, quantitative strategies, smart beta strategies, and passive strategies. Could you tell us a bit about each strategy?
Traditionally, ESG integration was associated with only listed equity fundamental strategies. However, over the past few years, other listed equity investment strategies are integrating ESG factors.
Fundamental Strategies: The report covers ESG integration in absolute valuation models, specifically the discount cash flow model. Investors can adjust forecasted financials, such as revenue, operating cost, asset book value, and capital expenditure, for the expected impact of ESG factors. They can also adjust discount rates and terminal value, as well as perform scenario analysis, in which an ESG-integrated company valuation is calculated and compared with a baseline valuation.
Quant Strategies: The quant managers that perform ESG integration have constructed models that integrate ESG factors alongside other factors, such as value, size, momentum, growth, and volatility. ESG data and/or ratings are included in their investment process and could result in the weights of securities being adjusted upward or downward, including to zero.
Smart Beta Strategies: In these strategies, ESG factors and scores can be used as a weight in portfolio construction to create excess risk-adjusted returns, reduce downside risk, and/or enhance a portfolio’s ESG risk profile.
Passive and Enhanced Passive Strategies: Passive strategies can incorporate ESG factors. One approach is to reduce the ESG risk profile or exposure to a particular ESG factor by tracking an index that adjusts the weights of constituents of a parent index accordingly. Enhanced passive strategies can make active investment decisions, such as adjusting index constituent weights or excluding certain stocks altogether to lower downside risk or outperform the benchmark. As a result, managers can integrate ESG factors into these strategies.
Many of our members are on the sell-side and are looking for more information on how they can integrate ESG analysis into their work. You’ve touched on this a bit already, but could you tell us a bit more about what you found speaking with those on the sell-side?
Sell-side brokers are producing ESG-integrated research either on a global basis or a regional basis, but mostly the latter. Both seem to be successful approaches, but it requires a fair amount of initial groundwork to achieve commitment from the sector analysts.
That said, several sell-side analysts explained that once sector analysts realised that ESG integration is about integrating all material issues, the tone of the conversation becomes very positive. Phrasing the issues as “ESG” can have a negative effect on the conversation and application. But by referring to a specific, material ESG issue — for example, cyber risk in banks or water scarcity in mining companies — rather than merely referring to ESG in general, sector analysts are likely to consider integrating ESG factors and possibly realise that they are actually integrating ESG issues without knowing that they are ESG issues.
My personal reflection is that there is a lot of enthusiasm among sell-side analysts who write ESG-integrated research about broadening the coverage and volume of ESG-integrated research. The sector analysts that work with them are also committed to analysing ESG issues in their research.
However, the resources and headcount allocated to ESG expertise is very limited, which is reflected in the low percentage of ESG-integrated research compared with all sell-side research. More expertise can be achieved if there are more resources allocated by senior management in sell-side firms, and more importantly, if there is more demand for ESG-integrated research from the buy-side.
The report touches on incorporating ESG integration when assessing external managers. Tell us a little bit about what you found.
At the PRI, we are seeing more and more asset owners asking external managers about their integration practices. The advanced asset owners have been asking these types of questions for several years now and have built in ESG assessments throughout their management selection, appointment, and monitoring process rather than creating a separate ESG process.
Their questions are increasingly becoming more technical — for example, focusing on integration practices, portfolio construction, and stock selection decisions, including specific stock and sector examples that demonstrate managers’ integration techniques and reveal their level of responsible investment conviction.
Asset owners are expecting proof of ESG integration. For example, one asset owner looks for evidence of ESG-integrated investment policy, ESG training, third-party and internal ESG research, an ESG-integrated investment process, and strong voting practices. They like to see investment managers initiate conversations around ESG integration and refer to ESG integration throughout meetings. Specifically, the fund managers and analysts should be talking about ESG issues.
Another interesting finding was asset owners’ ESG integration expectations vary depending on the characteristics of an external manager, such as its size, region, investment style, and level of ESG experience. For example, an asset owner may be willing to hire a fund manager from a smaller investment firm with fewer responsible investment tools and staff despite a larger firm competing for the same mandate that has more responsible investment tools and staff. The selection of the smaller firm is usually under the condition that the fund manager commit to improve their ESG integration capabilities.
It is important for asset owners to define the level and style of ESG integration in all mandates. Doing so enables asset owners to fairly evaluate each external manager’s integration practices, and it allows investment managers to clearly understand those expectations.
Tell us some about what you found when talking to investors about integrating ESG factors into the investment process. Were there best practices that emerged? Was there anything that surprised you?
We found many examples of best practices, all attempting to achieve the ultimate goal of increasing dialogue and buy-in for ESG integration. It is important for the investment decision maker to be fully aware and knowledgeable of the material ESG issues that affect the value of their holdings and portfolios. The majority of fund managers and analysts are either not valuing material ESG issues that can potentially affect the performance of their investments or are not aware that certain material factors being analysed are ESG issues. It is most likely the latter. By adjusting the investment process to incorporate ESG research, tools, and expertise, they can take advantage of the additional insight that can be gathered from ESG integration.
Identifying ESG risks and opportunities is crucial for effective ESG integration. The use of a materiality framework ensures that managers and analysts are considering ESG material issues every time that they make an investment decision. It is also best practice to combine traditional data and ESG data and analysis in databases, centralised dashboards, and research notes so that the investment decision maker has a holistic view of all risks and opportunities associated with a security.
During discussions with the PRI’s listed equity committees, I was surprised to find that there is not one optimal structure for all firms. Some firms are more suited for integrated investment teams, in which the fund managers and analysts are responsible for the ESG research. Other firms have found that it is necessary to have a dedicated ESG team that performs the ESG research and works alongside the investment teams. Both have pros and cons, but what these models highlight is the fact that structuring an effective ESG-integrated investment process is not straightforward and will take time to implement.
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