A Natural Fit

ESG and active management

A Natural Fit

ESG investing is on the rise, and active managers who've made it part of their investment process are leading the charge.

The recent upsurge of interest in ESG (environmental, social and governance) investing has raised eyebrows among those accustomed to viewing it simply as a niche approach.  However,  it’s important to recognize that ESG is rapidly evolving  from its origins in SRI (socially responsible investing) to take on a broader role as an indicator of sustainable earnings and growth in mainstream equity strategies. 

SRI strategies tracked by Morningstar have seen significant inflows since 2015.  In part, this trend reflects increased awareness of the social and environmental footprint left by companies, and the potential impact on share prices.  This is especially true for Millennials, who’ve grown up with issues like global warming, sustainable energy and gender equality and are more likely to view these as critical concerns. Institutional investors, too, are responding to greater scrutiny from clients seeking to steer clear of firms whose business practices could lead to unhappy surprises down the road, with some going so far as to associate ESG screening with fiduciary responsibility.

"ESG has grown not only in assets under management but also in the number of choices being offered"
Mary Jane McQuillen, ClearBridge Investments

However, the shift is also reflective of a growing body of evidence that ESG-friendly policies tend to be associated with higher-quality firms with solid fundamentals -- and a useful metric to help screen out firms whose choices may expose them to legal challenges, reputational damage or even outright bankruptcy.  What’s more, while for many years it was assumed the self-imposed restrictions of ESG mandates would hinder returns, it’s now apparent that an ESG orientation does not in and of itself create an impediment to performance competitive with traditional equity indexes.

 

Performance gap? Not lately…

A 5-year look at the S&P 500 vs. MSCI KLD 400 Social Index, indexed to 100

Source: Bloomberg.  Investors cannot invest directly in an index.  The MSCI KLD 400 Social Index is a capitalization weighted index of 400 US securities that provides exposure to companies with outstanding Environmental, Social and Governance (ESG) ratings and excludes companies whose products have negative social or environmental impacts.    

 

Beyond SRI: Screening for quality with ESG ratings

The traditional view of ESG is as a vehicle to express preferences about what kind of companies to invest in based on a particular moral compass. This “socially responsible” approach may mean avoiding stocks associated with negative consequences for public health, the environment, social justice and more. In its crudest form, that can mean simply excluding entire sub-sectors from an existing equity index (i.e. tobacco, petroleum). However, taking a more nuanced view in the hope of capturing alpha, some active managers have developed analytical models which rate commitment to specific ESG issues on a company by company basis.

With these models already in place, it’s a short leap for those same managers to integrate these proprietary ESG frameworks into more general stock-selection criteria – in some cases, to be used for specific strategies, and in others, as a fundamental part of their overall investment process.  Why would they take that step? Because both common sense and industry research now suggests ESG-friendly firms are more likely to sidestep issues that could derail earnings and hurt shareholders.   

"There is compelling evidence that governance and sustainability factors correlate with returns over the long term, and therefore have to be incorporated by fiduciaries when assessing risks and opportunities"
David Sheasby, Martin Currie

In devising a general methodology to assess a firm’s adherence to ESG, managers must address the fact that some inputs lend themselves to quantitative analysis; for example, the level of carbon emissions generated by energy producers -- data that U.S. firms are required to disclosure. However, many demand in-depth qualitative analysis– including many associated with corporate governance. Consider, for example, diversity policies.  On paper, one might seek to gather data on a firm’s hiring policies and the composition of its workforce and then evaluate the costs and benefits of its behavior over time, and the resulting impact on earnings, profits and shareholder value. 

But in practice, that’s hard to implement, given the difficulty in accessing and verifying relevant data in standardized fashion across different companies and industries. Clearly, assumptions and tradeoffs must be made in order to generate a workable framework. One solution is to adopt a relative approach -- seeking to assess a company’s commitment to a given issue relative to its industry peers based on a specific set of criteria, and assigning ratings or rankings which reflects this.   Those ratings can then be rolled up into a broader set of criteria used in security selection for specific strategies or classes of strategies.

The Active-ESG Connection

That kind of in-depth analysis is typically the province of active managers who are already committed to tracking and evaluating stocks on an ongoing basis; a passive-only strategy may find the cost of such analysis prohibitive, even if systematized via a rules-based model.  The greater the depth and nuance involved, the greater the potential advantage for active strategies to uncover pockets of opportunity that an ESG-indexed passive strategy might miss. In addition, active managers can also nimbly update their ESG ratings to reflect changes in corporate policy and behavior; that’s particularly important now, as companies scramble to accommodate pressures to comply with investors’ evolving expectations. 

But there’s another advantage to ESG in an active framework: it allows for the manager to borrow a page from the “activist” investor playbook and engage directly with the client over time.  A manager oriented toward long-term returns from fundamentally sound companies may well be working with the same firm for 5, 10 or even 20 years at a time -- which allows time to build relationships with management to effect change that is positive for both shareholders and stakeholders.   As ClearBridge Investments’ Jeff Schulze recently put it, “ESG is not simply a screen to take out companies from portfolios, it’s also represents an opportunity to help firms grow and move forward."

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