Environmental, social and governance factors are a pillar of investing, holding more than $30tn of assets after impressive growth of 34 per cent over the past two years. So powerful is momentum, the fund industry will most likely embrace a near 100 per cent ESG-based model by 2030.
Enhancing the ESG profile of a portfolio means applying some deviation from traditional cap-weighted indices. One way to do that would be simply to buy some ESG scores from an external provider and apply them to an actively managed portfolio. Another would be to track the chosen ESG benchmarks from index providers.
A third way will be on the agenda of active managers: an approach I call ESG-fundamental that puts sustainability and financials on equal footing. This approach integrates ESG factors into the traditional fundamental analysis to improve portfolio returns, followed up by active shareholder engagement to gain an information edge and drive changes in the most relevant ESG issues.
It requires specialist skills in three distinct areas: first, selecting the ESG factors that are material to a company; second, integrating them with other value drivers to deliver superior long-term risk-adjusted returns; and third, engaging with investee companies to ensure that they are managing financial and non-financial risks that matter to their survival and growth.
This is easier said than done. The key challenge is to define and measure outcomes, duly isolating the impact of pure ESG from that of other factors, given their potential interlinkages.
The ESG impact can also vary with the time horizon. Short-term returns are less impacted, or may even be negatively impacted, if integration avoids transient opportunities from periodic volatility spikes. After all, the main aim is to capitalise on two time-related forces at work: markets are slow in remunerating all ESG risks; yet their drivers — such as regulation, investor awareness, social habits — are constantly changing. Thus, integration rests on an adaptive price discovery process based on the market’s feedback loops.
Risk factors related to climate change are a case in point. Ten years ago, few investors considered them material. But the Paris Agreement in 2015 was a turning point.
Our studies show that ESG investing (on the basis of Amundi ESG scores) in equities was not adding value in the 2010-13 period. Since then, however, change has been evident. Where ESG adoption has been higher, such as in Europe, markets are rewarding ESG factors by pricing in their risks. In North America, however, a classic factor, such as quality, continues to have a bigger 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 instance, the environmental aspect was most significant in North America during 2014-17 but has since turned negligible. US President Donald Trump’s decision to withdraw from the Paris Agreement may be a factor. Conversely, in Europe, the same aspect has become most relevant, followed by the social aspect, relegating governance to the back burner.
Such geographical differences are a matter of detail. The main point is that ESG integration is not a one-off static activity; but one that needs to be constantly revisited to capture the prevailing mispricing while markets rely on adaptive learning.
The first source of mispricing is the discrepancies in the scoring systems used by different data providers. ESG scores for the same company can differ significantly, since most providers use proprietary definitions and data. For example, the correlation in scores between the two major providers, MSCI and Sustainalytics, is weak. Those active managers with access to superior data have a clear information edge.
An even more important 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 that is likely to evolve in future and how the change will affect non-financial as well as financial performance. Active managers are well placed to delve into such forward-looking aspects via their year-round meetings with their investee companies.
After all, for the future, I believe that it is the increase in ESG scores — rather than their absolute levels — that will drive the performance. In equities, it is important to assess all three components (E, S, G) but also focus on the key themes that may affect the proper functioning of our society, in particular climate and inequality.
Thus, the rise of ESG-fundamental will change the DNA of high conviction investing, as it targets double bottom-line benefits: do well and do good. Active management and ESG are a perfect match, as investors increasingly recognise that sustainable companies require sustainable societies.
Pascal Blanqué is chief investment officer at Amundi Asset Management and a member of The 300 Club