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11 June 2019

Adding value through ESG

As the development of ESG investing moves from policy to action, the provision of added value by asset managers has become much more important

 

There has been a well-documented global shift from active to passive strategies over the past ten years. 70% of equity asset managers in Japan are categorised as passive, and 50% are classified similarly in the United States. Today there are more index instruments tracking stocks than there are listed stocks, putting us in the position of being driven by followers of the market, rather than makers of the market.

The consequence of this shift has been a fundamental pressure on fees. This is evidenced by the fact that during periods of strong market highs, asset managers still face pressure due to a decrease in revenues instead of thriving. It is clear that asset owners are questioning the value of active management. There has also been a realisation that a focus purely on short-term shareholder returns does not generate into long-term value.  

Question of stewardship and shifting trends

This shift towards passive investing has had a particular impact on the question of stewardship. Since asset owners are now more exposed to passive strategies, they are also much more exposed to systemic risk than stock-specific or asset manager-specific risk. This translates into more in-depth thinking about how long-term issues, such as climate change and the rise of socio-economic inequality, might impact the economy, as well as index performance over time. This gives asset managers many opportunities to demonstrate value through their engagement to support passive strategies, becoming much more active in their relationships towards companies and mobilisation of shareholder rights.

In active management, there has been a trend towards more concentrated portfolios and longer-term holdings. Stewardship has become more central to the investment process with regards to how investors are interacting with companies, as well as the inclusion of long-term sustainability issues in conversations with management. This dialog between fund managers and companies demonstrates the next stage of ESG investing. Instead of being passive receivers of information, analysts are actively communicating the steps required toward generating long-term value for the environment and society – which contributes to shareholder value.

Application of data

Now that a certain amount of limited data is available around ESG, the industry needs to mature and become more sophisticated in terms of how that data is actually applied to the investment research process. It is no longer good enough, to simply rely upon third party ratings when it comes to integrating ESG data in the investment analysis; rather the application of that data needs to be performed by the financial analysts themselves to drive assessments.

According to Christopher Greenwald, Head of Sustainable and Impact Investing Research and Stewardship at UBS, who spoke at the ‘Reworking ESG’ thought leadership forum hosted by Style Analytics, this is because there are several limitations with current ESG ratings, including:

  1. ESG ratings are primarily historic in nature based on reported metrics from company annual reports and controversy news in the public domain that are then processed to generate an overall ESG score. While this approach is a good starting point, it has limitations because it does not help provide a scenario analysis that is forward-looking;
  2. Many of the ratings are far too broad, in that they address too many issues which can cause confusion more than anything else. Instead of a 100+-page company report, it is much easier for financial analysts to digest material that is focused on issues that really matter for that company and industry;
  3. Ratings are often disconnected from financial recommendations because they are provided by third party providers. ESG data needs to be analyzed in a similar manner to data derived from financial tools such as Bloomberg or Thomson Reuters, and the third party ratings should be viewed simply as a starting point. The real task for the financial analysts in the ESG integration process is to create their own assessment out of the integration process, based on how sustainability actually impacts companies from a financial perspective in the future.

The ideal would be for the investment industry to start having more conversations about how ESG can have highly material influences on companies, including shareholder value. Throughout this process, fund managers can demonstrate both the value of active management, and active engagement on the passive side in trying to change the process of interacting with companies.