Clearing the Air in ESG Investing

Is how a company makes money—and not just how much it makes—important to you? If so, you may be interested in “environmental, social and governance” (ESG) investing. But as the ESG investing realm gains popularity, confusion seemingly abounds over whether companies simply ticking the right ESG boxes will deliver superior returns. (In our experience, no one factor or set of factors outperforms permanently.) To help clear things up, here are some tips we think can assist you in navigating a still-budding investment space if it appeals to you and fits with your long-term financial goals, risk tolerance and other factors we think are crucial to determining anyone’s investment strategy.

Since ESG’s inception, a big question has perennially cropped up amongst commentators we follow: how to measure and compare companies’ progress outside traditional metrics like profits, revenues, gross profit margins (calculated as revenues minus cost of goods sold, divided by revenues, which we think is a good measure of the profitability of companies’ core business units) and market capitalisation (number of share outstanding multiplied by share price—the total market value of a company). Many research firms and index providers we monitor have since stepped in, introducing a series of ESG scores, which rate firms across a series of different criteria. Whilst these scores can be useful to help you avoid business activities you may object to or find counterproductive, we think it is important to note they are chiefly measures of operational risk. In our view, ratings can’t—and aren’t intended to—signal which firms will perform better in share-price terms; they are simply one input of many in that regard.

Furthermore, we have observed many financial commentators—and increasingly regulators—bemoan there is no consistent standard amongst ESG rating firms, as ESG factors are largely qualitative. For any given company, ESG rating firms can give wildly different scores, which we think highlights rankings’ inherent subjectivity.^[i] Even if two raters used the exact same information, they could award different scores based on the methodology they use. For example, when it comes to numerically assigning a social score—ranging from a corporation’s leadership diversity to its child or slave labour exposure—which one do they think is more important? (Presuming the company’s reporting on the latter is even accurate, given the complexity of multilayered overseas supply chains and potential lack of transparency.) Even when an issue is theoretically possible to measure, say the carbon emissions a corporation is responsible for, in practice, raters can generally only estimate that figure—another data limitation likely rendering comparison more art than science.^[ii] In our view, patchwork disclosure and hard-to-quantify variables often render ESG ratings a judgment call.

To us, these discrepancies aren’t necessarily negative, and they don’t mean you should ditch ratings altogether, but it does necessitate getting beyond third-party ratings. In our view, understanding ratings’ underpinnings should inform whether you agree with their conclusions. In other words, we encourage investors to dig in and apply critical thinking when examining ESG claims. Consider the EU’s slated green taxonomy, designed to classify whether an investment is environmentally sustainable.^[iii] Member states’ definitions reportedly differ markedly. France thinks nuclear should qualify as green, but not natural gas; Germany takes the opposite view.^[iv] Who is right? We think this shows how no purely quantitative framework can definitively tell you whether an investment is socially responsible or promotes sustainability. For guidance, we suggest investors seeking to apply ESG principles look for a manager who can explain differing methodologies to their own satisfaction and comfort.

ESG is just one of many factors investors can assess to meet their financial goals; in our view, it isn’t inherently superior or guaranteed to accomplish its purported aims. As such, if you decide to venture into the ESG realm, we think it is best to integrate it into a comprehensive investment process to make sure it aligns with your aims and longer-term financial goals (as well as your personal risk tolerance, cash flow needs and investment time horizon, which is the length of time your portfolio must work toward your goals). Overly relying on ESG scores could leave you short of your overall objective, especially when ESG scores are most likely widely known and therefore priced in (based on the widely held principle, which we agree with, that states share prices incorporate all widely known information near-instantaneously).

To shape an ESG portfolio consistent with your preferences and financial goals, we think it helps to start at a high level—with a top-down view of country and sector drivers along with their ESG-related risks or opportunities. With a broad picture of countries and sectors’ portfolio roles—including ESG factors like environmental regulation, social policy, economic and market reforms, labour and human rights—we think an ESG investor can develop a roadmap to follow.

Then, with your sector and country targets as a guide, you can incorporate ESG into your security analysis as you pick which companies to own. Ideally, in our view, this would involve evaluating a wide-ranging set of qualitative and quantitative data—from shareholder concentration and corporate stewardship to environmental impact and human or labour rights controversies. Based on our research, which demonstrates that top-level decisions determine the majority of portfolios’ longer-term returns, we find individual security selection doesn’t impact relative performance materially. We think this gives investors broad discretion to employ ESG factors into their portfolios without compromising returns in any meaningful sense.

So, if you are considering ESG investing, ask yourself a few questions. How well do you understand your financial professional’s approach to ESG, and how closely does this hew to what you aimed to accomplish? Does their ESG methodology make sense to you? Are ESG considerations well integrated into an investment process designed to meet your overall financial goals? In our view, the answers should go a long way in deciding which ESG approach is right for you, if any.