Some of the top active managers around the world have something in common – their portfolios are tilted toward environmental, social and governance (ESG) factors. But is this intentional or just an interesting coincidence? Are fund managers pursuing ESG factors strategically, or are they simply capturing ESG values in their pursuit of economic value?
Targeting value and getting values
It seems that when investors seek value these days, they often end up with securities that represent values – an alignment with increasingly popular environmental, social and governance (ESG) principles. In a recent research effort (Are ESG tilts consistent with value creation?),we took a closer look at potential causes and effects. In the process, we identified positive ESG tilts as consistent with many fundamental investment processes.
Our study explored the relationship between active manager portfolios and ESG tilts. We had heard that ESG might be value-detracting, so we expected to see a negative tilt in active portfolios. Instead, we discovered that many active managers, who are seeking to add value over their benchmarks, actually have positive ESG tilts. In a number of regions, more active managers have positive ESG tilts than negative ESG tilts.
This finding 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. Think of this as latent ESG.1
Targeting values and turning it into value
Investors who remember the early days of portfolio screening, often called socially responsible investing (SRI), may be hesitant about a strategy seeking positive ESG tilts. A limiting feature for the SRI of old was that the screens were not investment-based. Rather, securities that did not meet some social or environmental criteria might have been stripped out of the portfolio without considering the investment implications. While the portfolios were deemed “socially responsible,” they often did not meet investor expectations and therefore earned a bad reputation.
But screening is more typical than one might expect… and non-investment screens can even lead to good investment outcomes. Screens are all around us. Most managers already use screening to impose investment criteria on portfolios. What is different about SRI is why the screens are applied. Screening for investment criteria is one thing, screening based on a values judgment is quite different… or is it?
The key is starting with good portfolio management and focusing on outcomes. Current investment technology may allow investors to include both values and value in their portfolios. With appropriate attention paid to portfolio composition, factor exposures and good security selection, investment managers can impose some ethical screens on a portfolio and may not experience material differences in tracking error or return expectation.
ESG around the globe
Outside the U.S., ESG appears to be gaining credibility and acceptance in the field of active investment management. Some regions lead, others lag, but the net effect is an ongoing evolution from niche enthusiasm to mainstream trend. ESG is now considered additive to security analysis.2
Europe is the current global leader in this regard. According to Russell Investments’ Head of European Manager Research, Veronique Botton, “The active manager not incorporating ESG into security selection is the odd one out.” We are seeing similar leadership among European clients. Particularly in northern Europe we have several clients with ESG mandates, goals and beliefs. In Australia and Canada, investors are requesting mandates related to ESG. In the US, ESG-related reporting and discussion — along with some high-profile carbon divestitures — have become common themes for non-profits and many public funds. And Japanese clients have exhibited interest particularly in environmental issues through clean energy and efficiency technologies. Around the globe, some investors are expressing increased interest in supporting and benefiting from the inclusion of ESG analysis in their portfolios.
In addition to investors (asset owners and investment managers), other stakeholders are looking to corporations to be good global citizens. Customers may also be playing an important part by voting with their dollars for sustainable goods and services. Employees may prefer to devote their days to companies with good reputations, beneficial work practices and demonstrated environmental stewardship. As stakeholders begin to expect more from corporations than just profits, some companies are responding. ESG scores are visibly increasing across the globe.
Moreover, we have observed that:
- ESG-related shareholder activism is on the rise. It is possible that pressures exerted in recent years by stakeholders have started to have an impact.
- Global initiatives such as United Nations Principles for Responsible Investing (UN PRI) and the UK Stewardship Code are encouraging or even requiring transparency on ESG issues. Added transparency for ESG practices, combined with the rise of shareholder activism, has the potential to influence behavior and internal practices.
- Companies increasingly understand the importance of protecting themselves against reputational risk. This, in turn, may deem ESG as financially material. Indeed, initiatives are underway across the globe to adapt accounting practices for ESG issues.3
Understanding ESG and active management
Our research study is a starting point for understanding the role of ESG in portfolios. As more investors perceive that ESG-aligned investing is possible, and perhaps preferable, we may see a more intentional pursuit of ESG tilts in portfolios. To some extent, we already are seeing a trend toward purposeful ESG taking hold in Europe, Australia, US, Japan and other regions.4 While our studies do not directly link ESG tilts to added investment value in active portfolios, we believe that managers’ use of ESG-related information is additive to good active management. In short, careful evaluation of ESG factors is consistent with prudent active security selection.
For investors who favor ESG, they may find it is getting easier to align a portfolio to ESG whether they use dedicated products or simply rely on active managers with an inherent adherence to ESG factors. In some cases, investors may need to look no further than their active products to find they already have positive ESG tilts in place.
1 How might ESG information assist active managers in the security selection process? It is possible that ESG provides a new perspective. Consider governance. Transparency in dealings and strong accounting oversight might have prevented implosions at Worldcom and Enron, or even the Global Financial Crisis. Consider Environment: Awareness of environmental risks and best practices might have prevented the Gulf of Mexico oil spill by British Petroleum in 2010. Consider Social: Labor strikes and high rates of staff turnover might lead to lower levels of production in a highly competitive environment. These sorts of hidden risks and related risk management may be largely invisible in a pure investment analysis. Yet any weakness in risk management can contribute to volatility in a company’s value. Volatility in a portfolio can be expensive for investors.
2 ESG focused investments represent roughly 22% of the funds under management in the regions surveyed by the GSIA, as reported in the 2012 Global Sustainable Investment Review (page 35). Note that this is 22% of assets evaluated by GSIA, but not necessarily 22% of Russell universes. Our current understanding is that ESG analysis is rarely an explicit input into portfolio construction for the universes considered in this analysis.
4 While U.S. and Global ex-U.S. have some very similar properties, Japan and Pan-Europe (UK and Continental Europe) look a bit different. Japan ESG scores are dominated by E, or Environmental. In a densely populated island nation, such attention to Environmental is not surprising. Japan Governance scores are also markedly different from other economies’ scores. Japan’s long history of cross-ownership among large corporations and the insularity of corporate board memberships have long been noted as very different from other developed economies.
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First use: July 2015