How to integrate ESG data into investment portfolios

Much of what is considered environmental, social, and governance (ESG) data today has influenced portfolios for many years.

Take governance, for example. At a recent Bloomberg Data Speaker series event, Marina Niessner, VP of AQR Capital Management, said AQR has used governance signals since the firm’s inception in 1998.

“They weren’t connected to ESG back then, but thinking about companies having good governance and potentially better performance in the future is long grounded in academic research,” said Niessner.

“We’ve had those signals that we’ve constructed from raw data — [essentially] a lot of high quality accounting data — and now we can call them ESG.”

Denoting those signals as ESG is increasingly important as asset managers are under new pressures to embrace ESG in their investing strategies, and returns are not the only objective.

Evolving applications

Demand for ESG is changing. Naturally, there has always been the interest in alpha. Now, it is also about awareness.

“More recently, we’re seeing demand for the restricted stock lists that we’re getting, and also more of the value-based ethical investment [strategies] — where people are willing to trade off some alpha to build more ‘aware’ portfolios,” said Niessner.

Effectively customizing investment strategies using ESG intelligence depends on the goal of the portfolio and types of decisions being made.

At Warburg Pincus, which deals in private equity investment decisions, it is an investment evaluation criteria.

“During our due diligence process, we’ll take a look at ESG as a way to evaluate potential operational risks, reputational risks, or regulatory risks or red flags,” said Leela Ramnath, Director of ESG at Warburg Pincus.

Firms also have to be prepared to report on ESG.

“In Europe and even in Hong Kong, there are some listing requirements around ESG. So there it’s an actual regulatory issue… and in the U.S. market, right now the implicit expectation is for public companies to report on these things,” said Ramnath of ESG’s other role.

With the market for ESG investing growing worldwide — reaching $30 trillion in assets under management in 2018 — Ramnath noted that ESG is becoming an increasing consideration as private companies look to IPO.

Part of the process

To be effective, firms must weave ESG into their strategy and process, as opposed to just their sales pitch.

“This ESG conversation is not about product development. It’s not a product to sell, it’s a part of an investment process,” said Brace Young, Partner at Arabesque.

“You incorporate into your process either to get better returns or to align the stakeholders that you’re investing for to the things they care about. And there’s a spectrum,” said Young. “I think the big opportunity is to fulfill that customization and align the financial assets to the things that are important to the people that are giving you the money.”

Seizing that opportunity requires firms to figure out what actually works. That starts with strong data practices; companies must utilize consistent, quality data from trusted service providers, and should develop ESG methodologies that align to portfolio goals.

That often means looking for financial materiality. Depending on industry and geography, there are only certain types of ESG signals that actually influence stock prices and investors are interested in. Identifying what is most relevant requires extensive analysis inside specific verticals. The SASB materiality map provides a starting point for developing models for testing and iteration.

Foundation for insights

Identifying relevant signals also requires an understanding of ESG’s gaps.

Panelists at the Bloomberg event all noted that since all ESG data is self-reported, its “completeness” should never be assumed. Best practices are still being developed, but are growing alongside client demand.

Joshua Livnat, Managing Director of QM, whose team recently published a paper on ESG in the Journal of Portfolio Management and launched a product that uses ESG in its portfolio theory, says that when his sales teams speak with customers and prospects, “they get a nice foot in the door by introducing this type of research. It’s hot.”

It will likely get hotter from here, as the influence of environmental and social factors expands. As consumers’ values evolve, developing an ESG strategy now will help firms earn better insights on how ESG influences their portfolios’ values over time.

Robust data sources and management strategies lay the groundwork for understanding ESG influences. From that foundation, additive signals will follow.

“Today there is unconditionally materiality,” said Brace Young of Arabesque of ESG at the event. “I think as data gets better, it will be more and more powerful to make individual stock decisions.”