Why Active Portfolios are ripe for ESG investments
Environment, Social and Governance (ESG) investments have received notable attention across the financial media recently and empirical studies tend to agree on the benefits of ESG within investments. Friede et al (2015) aggregated evidence from more than 2,000 studies to find the base case for ESG to be empirically well founded, with the majority of the studies reporting positive findings between ESG investing and corporate financial performance. At the end of 2018, the Global Sustainable Investment Alliance claimed a total of $31 trillion as invested in sustainable investments globally which was a 34% increase since their biennial report was last released in 2016.
According to Morningstar Data, over the course of this year in the UK alone, an average of £124million a week has flowed into ESG funds; 70% of which are actively managed. The Lyxor/Dauphine Research Academy found that, historically speaking, investors’ approach to ESG investing has been active in nature though passive ESG investment assets have grown at a rate of 33 percent per annum over the past 5 years, compared with 11 percent for active funds.
While popularity for ESG has increased and the benefits are broadly agreed, the approaches in which it is applied in funds varies greatly. One approach is quantitative which seeks to provide a numerical value combining E, S and G factors into a model to rank and score companies. Interestingly a paper by Berg et al (2019) showed the correlation of these scores from five prominent third-party data vendors was only 0.61 (compared with credit rating agencies Standard & Poor’s and Moody’s who had a correlation of 0.99).
Clearly this approach is subject to divergence from scope, weighting, and aggregation and not helped by the lack of standardisation within the industry despite pushes from the Sustainable Accounting Standards Board (SASB) as well as various ISO standards (e.g. ISO 14001). It is these inefficient environments by nature that active managers stand to work well in.
A qualitative approach enables active managers employing fundamental strategies to really benefit from conscious judgements and analysis of companies’ potential and commitment to E, S, and G that can’t easily be quantified. Specialist knowledge, engagement with the board, and shareholder activism are some of the ways active management can further influence ESG processes and even find turnaround companies with improving ESG that can pick up added alpha in the long-term.
Now seems to show more than ever the need to understand what lies behind a simple ‘ESG’ label on an investment, and something a trusted partner like Linear DFM can do. Linear seeks to understand the approaches in ESG integration used by any active managers before they make it into our fund universe or any portfolio. While there is benefit to ESG, the divergence within the approaches necessitates the need to fully understand on a case by case basis what ESG is actually covering.