Investment professionals worldwide currently manage around US$70 trillion of “other people’s money”. Practitioners in financial centres from Boston to Sao Paolo and Cape Town to Zurich are integrating sustainability thinking into their investment decisions. Investment decisions still overweight fear versus greed and some argue this is due to changing investment mores. But perhaps the driver is the growing evidence and experience that environmental, social and governance factors may affect performance. It is a risky business because returns are variable in the fledgling ESG sector. In addition, portfolios and styles are heterogeneous and related performance metrics are an inexact science. Investors’ drive to understand and integrate the sustainability meta-theme into investment practice has created increased demand for integration of relevant data. A race is on between specialist RI houses and major money managers to polish their analysis and integration of ESG factors in order to secure competitive advantage. The best ESG talent may walk, and the current fluid markets have introduced new M&A opportunities for buying sustainability specialists orhouses. Differences in the quality of sustainability investment practice are emerging and will become more distinct. “Investment-as-usual” is changing toward ESG integration, but execution remains a huge challenge. Practical problems for money managers and institutional investors occur somewhere between the bright idea, the spreadsheet and the trading model. In our assessment of the ‘state-of-the-art’ in money management based on sustainability themes, execution problems include speed of access to data, ability to manipulate and compare across regions, availability and “refresh rate” of ESG factor research and the frequency and currency of the information upon which major ESG analysis is made. No objective assessment of sustainability or performance attribution for the integration ESG factors, is yet available. The result? A money manager in Norway with a global, environmental-impact mandate seeking the best-of-breed performer in the oil & gas sector will spend a long day working their Bloomberg or Factset software models to present an investment conviction based on ESG factors. If data must be cleaned and manipulated before testing hypotheses, and performance
attribution is unclear, new investment ideas will remain unexplored. Why risk one’s investment reputation when the rules of the game are fuzzy? ESG data and analysis can also have differing degrees of time-lag baked in, as one would expect to find in any analysis relying on a mix of public and proprietary resources. Furthermore, evaluating sustainability is seldom forward looking: GE’s US$10 billion “ecomagination” businesses have only recently been rewarded with better ESG ratings, even by shops with deep ESG research teams. Lagging analysis remains a major barrier to comparing and contrasting investment ideas. A brief history of responsible investment over the last three decades suggests it has evolved through four stages. Investment houses first focused on screening as avoidance or on proxy voting systems as a direct ESG intervention. They then moved to working on engagement/active ownership where politically possible. Next to gain favour was the wave of “best-in-class” responsible investment products, few of which were truly innovative. In the fourth and current phase, managers are allocating a certain portion of their research to extra-financial issues. Professional standards are lacking, making the work to develop ESG protocols in stock selection challenging. Our work in manager selection based upon demonstrated ESG competencies still remains more art than science. Nonetheless, our experience of sustainability integration in established fund managers is that ESG factors are already implicit, but not all are material and not all risks are understood. Perhaps it is no coincidence that a cross-reference of the major US banking names that have melted away in the current banking crisis to the 2008 CERES/Riskmetricsclimate risk governance study laggards offers anecdotal evidence of a “proxy for management quality” argument. The better money managers adjudicate on what they want to integrate. The best are becoming adept at how they integrate them. Emerging markets present the greatest challenge to integration because information is more expensive but also more valuable. Major institutional investors have big enough teams of portfolio managers and the investment clout to develop relationships with local investors, regulatory agencies, stock exchanges and even companies themselves. The largest US pension fund, CalPERS, has the best example of this approach in the CalPERS Corporate Governance Principles for Emerging Markets. Overall, the positive momentum for the sustainability meta-theme is reflected in the informal conversations we are having with investment practitioners around the world through professional networks like the Chartered Financial Analysts association, or specialist efforts like the International Corporate Governance Network Global Corporate Governance Principles, Carbon Disclosure Project, Principles for Responsible Investment, World Business Council for Sustainable Development and CERES, the US environmental investor coalition. The current behaviour of money managers to explicitly deal with ESG integration includes:
- Buy Lists: Choosing to license ESG indexes from established brands or from branded index/data providers. Using strong brands explicitly or implicitly as buy-lists provides a fast route to building a competency at the product level.
- Tracking: Limiting variability of performance against established benchmarks by tracking benchmarks closely. Integration vests at portfolio and product level. This supports the overall pensions trend to absolute returns from 2007.
- Internal: dedicating internal research effort to establish house view, selectively incorporating specialist ESG vendor input. New analyst competencies emerge, and will emerge as global, sector or thematic specialists.
- Co-development: developing new coverage directly with specialist ESG data vendors by expanding names or criteria in the vendor ratings. Intellectual property issues lurk, but product development is more likely, with risks shared.
- Collaborative development: Exploring non-competitive situations where collaboration with peer money managers may be accomplished. As the market evolves, collaboration will transition to competition.
- Activism-only: Deferring ESG integration to proxy action only, separate from portfolio decisions. The opportunity and the ability to manage reputation is better than the opportunity for ESG-attributed returns.Mainstream investment today comfortably includes the language of climate change, executive compensation, board diversity and green consumption. But ESG data collection, which can be a competitive advantage in its raw data form as well as through analysis, remains expensive, and is becoming more so. Major investment houses have cut back on proprietary research since the 2003, and ESG faces the same axe. Moody’s cut their corporate governance rating team in mid-2007, a decision that has surely haunted them these past weeks. Money managers must make the trade-off between a deeper understanding of ESG factors on investment decisions and the added costs of the research that can help them to do so: expenses are always a drag on performance. Our advice is to start experimenting now with ESG factors, and to learn quickly.
Graham Sinclair is an ESG architect and sustainability investment strategist at Sinclair & Company http://sinclairconsult.com