Environmental, social and governance factors are a mainstay of investing, holding over $30 billion in assets after an impressive 34% growth over the past two years. The momentum is so strong that the fund industry will most likely adopt a nearly 100% ESG-based model by 2030.
Improving a portfolio’s ESG profile involves moving away from traditional market-cap-weighted indices. One way to do this would be to simply purchase ESG scores from an external vendor and apply them to an actively managed portfolio. Another would be to track ESG benchmarks chosen from index providers.
A third path will be on the agenda for active managers: an approach I call ESG-fundamental that puts sustainability and finance on equal footing. This approach integrates ESG factors into traditional fundamental analysis to enhance portfolio returns, followed by active shareholder engagement to gain an informational advantage and drive change in the most relevant ESG issues.
It requires specialized skills in three distinct areas: first, selecting the ESG factors that are material to a company; second, integrate them with other value drivers to deliver superior long-term risk-adjusted returns; and third, to engage with recipient companies to ensure that they manage the financial and non-financial risks that matter to their survival and growth.
It’s easier said than done. The main challenge is to define and measure outcomes, duly isolating the impact of pure ESG from that of other factors, given their potential interconnections.
The ESG impact may also vary with the time horizon. Short-term returns are less affected, or may even be negatively affected, if integration avoids the transient opportunities of periodic volatility spikes. After all, the main objective is to capitalize on two time-related forces at work: markets are slow to remunerate all ESG risks; yet their drivers – such as regulation, investor awareness, social habits – are constantly changing. Thus, integration relies on an adaptive price discovery process based on market feedback loops.
A good example is the risk factors related to climate change. Ten years ago, few investors considered them important. But the Paris agreement in 2015 marked a turning point.
Our studies show that ESG investing (based on Amundi ESG scores) in equities did not add value over the period 2010-13 period. Since then, however, the change is evident. Where ESG adoption has been higher, such as in Europe, markets reward ESG factors by pricing their risks. In North America, however, a classic factor, such as quality, continues to have a greater influence on portfolio returns.
Our analysis also shows that ESG integration could benefit actively managed portfolios in most regions and the respective impact of E, S and G varies over time. For example, the environmental aspect was the most important in North America between 2014 and 2017, but has since become negligible. US President Donald Trump’s decision to withdraw from the Paris Agreement could be a factor. Conversely, in Europe, the same aspect has become the most relevant, followed by the social aspect, relegating governance to the background.
These geographic differences are a matter of detail. The main point is that ESG integration is not a static one-time activity; but one that needs to be constantly revisited to capture mispricing as markets rely on adaptive learning.
The first source of poor pricing is discrepancies in the rating systems used by different data providers. ESG scores from the same company can differ significantly, as most providers use proprietary definitions and data. For example, the correlation of scores between the two main providers, MSCI and Sustainalytics, is weak. Active managers with access to superior data have a clear information advantage.
An even bigger source of price anomalies is the static nature of all ESG data. They simply provide a snapshot without explaining why the company has a certain rating, how the rating is likely to change in the future, and how the change will affect non-financial and financial performance. Active managers are well placed to deepen these forward-looking aspects through their meetings throughout the year with their beneficiary companies.
After all, going forward, I think it’s the increase in ESG scores – rather than their absolute levels – that will drive performance. In actions, it is important to assess the three components (E, S, G) but also to focus on the key themes that can affect the proper functioning of our society, in particular the climate and inequalities.
Thus, the rise of ESG fundamentals will change the DNA of high conviction investing, as it aims for a double benefit in terms of results: doing well and doing well. Active management and ESG go hand in hand, as investors increasingly recognize that sustainable businesses need sustainable societies.
Pascal Blanqué is Investment Director at Amundi Asset Management and a member of the Club des 300