The growing role of ESG investing in portfolio management

Sustainable investing is gaining momentum among financial market participants. To meet rising investor demand, more asset managers are incorporating “environmental, social and governance” considerations into their investing strategies and an increasing amount of research suggests that their approach aligns with positive financial returns. With a myriad of factors to consider, how can asset managers make sense of the current market landscape to more effectively incorporate ESG information into their investment strategies?

According to the Global Sustainable Investment Alliance’s 2016 Global Sustainable Investment Review, sustainable, responsible and impact investment assets – which by definition include ESG considerations – reached nearly $23 trillion last year, a 25% increase from 2014. About $9 trillion of those assets were in the U.S. Bloomberg’s 2016 Impact Report found that “1 out of every 5 dollars under professional management in the U.S. is managed using sustainable and responsible investment strategies.”

At the same time, market dynamics are evolving, Brett Schechterman, global head of fixed income platform solutions at UBS Asset Management noted at a recent Bloomberg panel on the current fixed income landscape. “It’s now, I think, a bit of a mix between people (investors) who want access to ESG factors in a passive or smart beta context versus people who are looking to active managers to incorporate ESG components into their investment processes as part of portfolio construction.”

The ESG inflection point

Asset managers are reaching an “inflection point,” where they are now blending their own credit research with standard input from market data and research providers. The resulting output can include proprietary scores and historical ESG industry and company performance data. “They’re trying to tilt accordingly to standard indices and trying to differentiate (by generating alpha) that way,” Schechterman said.

Venky Venkataramani, CFA, Global Head of Fixed Income Beta Solutions at State Street Global Advisors, mentioned that his firm is seeing interest from clients for ESG factors in their portfolios and that more tailored indices would be helpful in meeting their overall investment objectives. Weighted properly, indices that incorporate ESG factors will allow them to keep track of their progress on both the social and investment fronts.

Another dynamic  to watch is the divergence between government agencies and investors when it comes to the priority of ESG factors. Despite recent announcements from Washington about intentions to roll back environmental protections and re-emphasize the use of a coal, for example, Schechterman expects investors to continue pressuring companies to address their concerns – regardless of government action.

“I think the investor base is going to be stickier to see how those long-term outcomes play out,” Schechterman said.  Venkataramani added, “This investor base will ultimately demand similar (or better) return outcomes from ESG strategies.”

Early performance indicators

In the securities market, some studies report that positive ESG tilts are often evident in solidly performing funds. Russell Investments studied the issue in 2015, finding that many active managers looking to increase value over their benchmarks have seen positive ESG tilts. In multiple geographies, the number of active managers with positive ESG tilts outpaces the number with negative ESG tilts. Although the reasons are unclear, considering ESG during portfolio construction often results in stronger performance. According to the CFA Institute, it may have to do with how ESG Key Performance Indicators are often effective evaluators of both single-investment risks and overall portfolio risks.

Research from Barclays on the impact of ESG on the performance of US investment-grade bonds, found that portfolios that maximized ESG scores outperformed the index. One reason for the outperformance?  According to their report Sustainable investing and bond returns, they addressed the impact of a company’s low ESG score on associated subsequent credit rating downgrades and overall negative returns.  After testing this theory, they were able to show that “bonds with low governance scores experienced a consistently higher rate of subsequent downgrades than those with high scores. “

Does this imply that ESG considerations could be a valuable measure of risk? As more investors seek to align their portfolios to include investments that have a positive impact, many are looking beyond traditional financial and accounting data. ESG data has the ability to expose potential risks that could negatively impact a company or industry in the future, such as any practices that may spawn regulatory action or large operational or business changes.  Research in the Barclays’ study found that more investors are becoming “prudent to avoid investing in companies that have a detrimental impact on the world.”

The data horizon

Yet, investors and portfolio managers remain concerned with the inconsistency and lack of data they need to effectively incorporate ESG information into their investment strategies.  The Bloomberg Impact Report cites a PwC study that found only 29% of investors are confident in the information they are receiving.

Groups such as the Sustainability Accounting Standards Board and The FSB Task Force on Climate-related Financial Disclosures are aiming to align many of the ESG reporting frameworks to bring consistent and transparent standards to investors, issuers and the market.

This development will be critical for asset managers to align their portfolios to meet the altruistic needs of a growing number of their investors, while still maintaining financial performance.

Request a demo.