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 more people invest on the theory ESG investing adds value, they debate if companies simply ticking the right ESG boxes will deliver superior returns—and, naturally, confusion abounds. (Not least the confusion inherent in the incorrect presumption any one factor or set of factors outperforms permanently.) To clear things up, here are some tips to help navigate the muddy waters.

Since ESG’s inception, a big question has loomed: how to measure and compare companies’ progress outside traditional metrics like profits, revenues, gross profit margins and market cap. In stepped research firms and index providers, who introduced a series of ESG scores, which rate firms across a series of different criteria. These scores can be useful to help you avoid business activities you object to, but it is important to note they are chiefly measures of operational risk. Ratings don’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, as investors—and increasingly regulators—bemoan, there is no consistent standard, 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. 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 labor 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 the notorious 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 only estimate that figure—another data limitation rendering comparison more art than science. Patchwork disclosure and hard-to-quantify variables mean ESG ratings are, quite often, essentially a judgment call.

To us, that doesn’t mean you should ditch ratings altogether, but it does necessitate getting beyond third-party ratings. Understanding ratings’ underpinnings should inform whether you agree with their conclusions. In other words, dig in and don’t check your brain at the door. Consider the EU’s slated “green taxonomy,” designed to classify whether an investment is environmentally sustainable. Member states’ definitions differ markedly. France thinks nuclear should qualify as “green,” but not natural gas; Germany takes the opposite view. 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, investors seeking to apply ESG principles should look for a manager that 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, and it isn’t inherently superior (or guaranteed to accomplish any pet sociological aims you might have). 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 your aims and long-term financial goals are accounted for. Overly relying on ESG scores could leave you short of your overall objective, especially since those scores are widely known and therefore priced in.

To shape a 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, labor and human rights—an ESG investor can develop an allocation roadmap to follow.

Then, with your sector and country targets as a guide, incorporate ESG into your security analysis as you pick which companies to own. Ideally, this will involve evaluating a wide-ranging set of qualitative and quantitative data—from shareholder concentration and corporate stewardship to environmental impact and labor or human rights controversies. Because 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.

Hat Tip: Responsible Investment Senior Program Manager Seth Groener and Research Analyst Timothy Schluter.