ESG Investing – do managers invest consistently?

Editorial note: This post first appeared on our sibling blog, The Wire,  and was produced in the U.K. for a European audience in July 2015.

I’m passionate about environmental, social and governance (ESG) investing. To be more specific, I am passionate about understanding investment manager processes, and about making ESG easier to navigate for our clients. As head of European and UK Manager Research, I’ve been fascinated by the development of ESG awareness and the increasing importance that many clients attach to ESG factors, particularly in Northern Europe. I’m also deeply interested in the extent to which the investment manager community is integrating ESG into their investment processes.

But let’s be clear – enthusiasm about ESG is not enough. ESG is not a substitute for a good investment process. What I want to find are skillful investment managers who can genuinely integrate ESG into an investment process that adds value for clients.

Recently, some of my colleagues published research showing that many active investment managers own portfolios that have positive ESG tilts. This suggests that positive ESG tilts are consistent with managers’ intent to add long-term value through security selection. While the manager may or may not be purposefully screening for ESG factors, their investment criteria are identifying securities that in fact result in significant ESG tilts.

That was an interesting start, but only one step on a journey to a better understanding of ESG integration in manager processes. One of the immediate follow-up questions that arose was ‘if a manager portfolio historically has had a positive ESG score, can we count on that manager to have a positive score in the future?’

It’s important to understand whether ESG factors really are baked into an investment manager’s process or whether they are merely coincidental. After all, the last thing a client wants to do is to appoint an ESG-positive manager only to find that, like Dr. Jekyll and Mr. Hyde, they undergo a negative transformation!

So I was deeply interested to see our latest research that investigates this very point. For the statistically-minded, we used ESG score data from an independent third party, Sustainalytics. We then used two methods for identifying ESG score stability in managers: (1) rank correlations (using the Spearman1 method and a standard Pearson correlation2) and (2) a transition matrix to measure the year- on-year change in ESG score for the managers in our universe. The take-away was that a manager’s current ESG score is a pretty strong indicator of where that manager’s ESG score will be a year out – hence manager portfolios with positive ESG scores are likely to maintain those positive scores over time.

For more on this research, please see a recent article by my colleague, Leola Ross, “ESG: Does investing for values generate investment value?

1 Definition: In statistics, Spearman's rank correlation coefficient or Spearman's rho, named after Charles Spearman and often denoted by the Greek letter \rho (rho) or as r_s, is a nonparametric measure of statistical dependence between two variables. It assesses how well the relationship between two variables can be described using a monotonic function.

2 Definition: Pearson product-moment correlation coefficient, also known as r, R, or Pearson's r, a measure of the strength and direction of the linear relationship between two variables that is defined as the (sample) covariance of the variables divided by the product of their (sample) standard deviations.