Sustainable investing (SI) is a confusing field, with lots of different concepts and approaches. We will discuss twelve observations that should help asset owners find their way.
There are many strands of SI, with different motives, approaches and results - just like investing in general. Motives range from ethical, to thematic and simply better analysis - typically via ESG integration. Different motives also mean different approaches, even within firms, as teams tailor their SI approach to their overall investment beliefs and processes. More generally, sustainability is a very wide concept, with a wide number of issues within the baskets of E (environmental), S (social) and G (governance).
SI is often equated to one of its strands, ethical investing, which aims to achieve ethical results first and financial returns second. Most SI strategies are not ethical though. Of course, they do take minimum ethical standards into account, but raising companies' ethical standards is typically a nice by-product, not a goal in itself. Rather, ESG integration strategies seek to be better positioned for a changing world (top-down) and to make a better assessment of company risk than via purely financial metrics (bottom-up).
Some strands of SI exclude a lot of companies from their universe, which reduces their opportunity set and their likely performance (see the next Observation). Of course, they are free to do so. However, most ESG integrated funds and asset managers choose to engage rather than exclude, which means they have a rather short exclusion list (at most a few dozen stocks) that does not hurt performance.
Some funds, especially of the ethical or impact variety do indeed give up financial performance for societal performance. This is famously documented in the outperformance of ‘sin’ stocks - tobacco, gaming and alcohol - by Hong & Kacperczyk (2009). But ESG integration certainly does not give up performance: it actually tries to boost risk-adjusted returns by limiting risk and seeking exposure to opportunities.
Derwall et al. (2011) find that values oriented (ethical) strategies indeed underperform mainstream strategies, whereas profit oriented SI strategies (that seek to make better decisions based on ESG data) actually outperform mainstream strategies. In fact, there is quite some academic evidence that ESG data contains information that is not yet fully captured in financials.
This one follows from the previous one: as SI strategies are perceived to give up financial performance for societal performance, they are also perceived to be at odds with fiduciary duties. However, most SI strategies do not give up financial performance for societal performance.
One could assess a company's sustainability across hundreds of criteria, and many factors will need to be scanned to avoid red flags, but only a few are so material that they are likely to decide about the future of a business model and hence stock performance. These material issues vary by industry and even within industries. A recent Harvard Business School paper (Khan et al., 2015) documents the outperformance of companies that perform well on their most material ESG issues. Conversely, it finds that firms that score well on immaterial issues actually underperform. The authors identify a few dozen most material issues per industry, but I suspect their results would be even stronger if they identified fewer.
The importance of materiality cannot be stressed often enough. This is the main misunderstanding between investment analysts and sustainability analysts. Quite often, the sustainability analyst doesn't understand investment needs and he (or she) will bombard his investment counterpart with all available sustainability data on a firm. Most of that data will prove of little use to the investment analyst, who may become cynical about all sustainability data.
The main role of SI rating agencies lies in gathering and condensing SI data for investors. That is very useful for purposes such as screening and quant strategies. But ratings also have limitations, such as generic weightings of factors that ignore the abovementioned materiality. Conclusions are sometimes very wrong. So rather than taking ratings as the endpoint of analysis, the serious fundamental analyst better uses them as a starting point.
It is already quite widely appreciated that companies with better sustainability profiles tend to have lower financial risks as well – these profiles might even be considered a proxy for management quality. But unfortunately, many people seem to stop there and see sustainability as a risk reducing factor only. That is a pity, since it is also about opportunities, as companies can derive serious competitive (dis)advantages from their most material sustainability factors - factors that affect cash flows, not just their cost of capital. Think of a pharmaceuticals company that grows faster than its peers due to superior human capital and innovation management; or a mining company that has lower costs due to its great management of local stakeholders.
Let's be clear: it typically takes years to achieve serious ESG integration. We started in 2009, but only achieved analyst acceptance by 2013. The explanation is simple: it is hard to change behavior and ESG analysis needs to show its added value before analysts will start using it. And even then, you will get into discussion about semantics (what is ESG and what not?) and you still face the question of how to actually do it. How do you make sure that ESG information ends up in investment decisions in a meaningful and consistent way? The exact answer will depend on the team and its investment process, but in in any case, you will need a disciplined approach and a strong framework.
The good news is that the hard work pays off in terms of better decision making. Our ESG integration has deepened our understanding of risk, opportunities and business models, helping us to avoid costly mistakes and identify undervalued opportunities.
Analysts will often say that putting numbers on sustainability is too subjective, that it cannot be measured or that it is already implicitly in their models. That is too easy. In effect, this usually means that they set the impact of sustainability at zero. And that typically means it does not affect decision making. And that's bad. Of course data aren't great, but I suspect people simply don't try hard enough or lack the courage to quantify sustainability. We therefore require our analysts in their investment cases to explicitly quantify ESG's competitive impact on the value drivers. Consultants like KPMG and EY go even further and quantify the societal impact of ESG issues. As for the subjectivity argument, how about the other forecasts that analysts put into their models?
Lots of people doubt whether SI makes sense, and suspect it is either misguided idealism or a marketing gimmick to attract naive clients. And in quite some cases, that might be true. But there is substance behind SI: profit oriented SI funds are backed by strong logic (and some academic evidence) in believing that their SI approach helps drive performance. There is also a grey area: some asset managers have dozens of ESG analysts that determine whether stocks qualify for the investment universe (impact beyond a gimmick), but fail to have their investment analysts and portfolio managers actually take sustainability information into account (not integrated).
Labeling something 'sustainable' is easy and might be close to mainstream in some parts of Europe, but serious approaches to SI are definitely not mainstream. And in most of the rest of the world, even the labeling is still far from mainstream. Interest is picking up, but in the land of the blind, the one-eyed man is still king. Advanced asset owners are aware of this and identify the best SI practices by asking questions that go well beyond PRI compliance.
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