Experienced financial advisors have seen their fair share of fads and many are quick to throw ESG into that toss-off bucket. But many portfolio managers disagree, insisting sustainability integration is merely an extension of good old-fashioned fundamental analysis.
“ESG is important to investors because of the need for a deep understanding of the factors that drive value today, many of which are intangible assets,” says Dan Hanson, CIO of Ivy Investment Management Company and parent company Waddell & Reed.
“Intangible assets such as intellectual property or reputation are harder to value than physical assets and are closely linked to ESG factors. Bad labor practices or contravening environmental protection laws can impact their value significantly,” says Caleb Tuten, an investment analyst at Wells Fargo Investment Institute.
Between 1975 and 2015, the contribution of intangible assets to the value of S&P 500 components flipped from below 20% to more than 80%. Many see ESG integration into fundamental analysis as a means of obtaining a more holistic view of an investment and a more accurate view of future risk-adjusted returns.
For effective integration, materiality is critical, says Casey Clark, global head of ESG investments at Rockefeller Capital Management. “There’s a lot of noise relative to the signal,” says Clark. “We try to focus on the issues that can drive the investment case.” Rockefeller’s process involves mapping more than 30 separate ESG issues across 77 industry sectors to determine their material impact on risk-adjusted returns.
“Treatment of human capital is particularly important in the software sector,” explains Hanson. “But you need to use old-fashioned shoe leather as well as new data sources to understand how any firm treats its workers. In a more capital asset-intensive sector, environmental factors might offer a stronger indication of efficiency.”
Unlike some firms, Rockefeller does not set minimum criteria, preferring not to rule out underperformers. Clark sees his funds’ role not only as generating returns for investors but catalyzing ESG-related improvements. Constructive engagement that encourages companies to improve their practices can generate stronger alpha than simply investing in companies that already lead in that regard, he notes.
Investors who want to understand the rapidly-evolving sustainability investment landscape can turn to resources such as the Wells Fargo Investment Institute’s ESG Analysis Assessment Framework. Tuten describes existing bottom-up approaches, relying on the ESG scores of individual portfolio components, as incomplete at best. Instead, Tuten’s team examined the investment processes of 2,000-plus funds, across asset classes and investment styles, to determine how they use material ESG factors to drive risk-adjusted returns.
WFII assigns qualifying funds one of four labels to rate how they integrate ESG: “aware,” “integrated,” “key driver” or “impact leader.” An “integrated” fund might apply ESG analysis during stock selection and portfolio construction, its ESG specialists focusing perhaps more on risk mitigation than alpha generation. Meanwhile, a fund labeled “key driver” might have an ESG analyst as portfolio manager, overseeing a proprietary scoring methodology that requires components to meet minimum ESG criteria.
Ultimately, the blend of data and judgment, or the balance between risk and return, will vary. At UBS Global Wealth Management, due diligence teams evaluate funds, weighing how ESG is integrated into their investment process. Head of sustainable and impact investing Andrew Lee says much comes down to evidence of commitment.
“There should be a belief that this approach enhances understanding and provides a more holistic view of the investment. The process and the reporting should consistently reflect the fund’s strategy and objectives,” he says.
Indeed, levels of integration are such that Rockefeller’s Clark predicts ESG-related job titles such as his will disappear. Already ESG specialists pick stocks and sit the same exams as investment analysts. “Today, they complete each other’s sentences; in five to 10 years, the strategies will merge and ESG labels will be dropped,” he says.
At Ivy Investments, that shift has already taken place. “Financial advisors should focus their due diligence on whether funds have a disciplined philosophy and process that integrates ESG factors to understand business quality, rather than as an afterthought,” says Hanson.
“This is not a fad. This is taking financial planning and behavioral finance to a new level,” says Tim Williams, director of education initiatives at the Money Management Institute.
To offer further insight, the MMI and The Investment Integration Project issued a sustainable investment due diligence guide. The report distinguishes between products that are financially-driven, client-driven, manager-driven or impact-driven, arguing these need different evaluation approaches in terms of intentionality, philosophy, process, people and performance.