No Shortcuts to ESG Integration
The rise in focus on ESG has brought an interest in hiring ‘ESG specialists’, but to truly integrate ESG into the investment process all investment practitioners need to be ‘ESG generalists’ at a minimum.
William Bryant, Head of Advisory
Christina Rehnberg, Senior Associate
A cartoon has been doing the rounds on LinkedIn illustrating that the fastest thing on earth at the moment is people becoming ESG specialists. What this points towards is a misconception around how complex ESG is and how ESG should be thought about from an investment perspective.
Over the years that our team members have looked at responsible investing and ESG, the expectations have changed significantly. This is especially true within the alternatives market, where investors are paying a higher fee in the hope of a better researched and higher quality product – or more alpha.
The meme has an element of truth in it. If one looks at the long-only world, whether that is equity or credit, any fund manager that is seeking to sell their product to an institutional investor in Europe, Canada, or Australasia needs to have robust explanation of how ESG is taken into account. Even in the US, when pitching products to Public State Plans, Endowments or Foundations, and to Private Wealth Groups, the existence of strong ESG credentials has become key. It follows that, some of those involved in the selling of these products have been quick to latch on to the necessity of being able to ‘talk a good game’ when it comes to ESG. What is a strong ESG credential?
Although improving rapidly, there is still a significant challenge around the transparency and use of information within the ESG space. Capturing relevant ESG information on security issuers is difficult and linking that to the view on financial performance is even more challenging. Currently, there is no clear globally accepted definition of what constitutes ‘good’ ESG performance at the firm or fund level. In the long-only world, where investments are viewed in fewer dimensions than in the alternatives space, defining a company as ‘good’ or ‘bad’ from an ESG perspective has come to the fore; this may be due to the nature of benchmarking and tracking error that is significant in the space. In the world of alternatives, the limited definition of mandates and the lack of benchmarks gives managers greater flexibility, which has brought greater elements of confusion when thinking about ESG. For instance, as an active equity long-short manager, is it appropriate to be long a company that is currently marked poorly by a backward-looking ESG ratings provider, but has initiated a program of change that will lead to positive momentum with regards to ESG ratings, and hopefully, positive stock price appreciation? Likewise, is it appropriate for that manager to be short a company that is far ahead of many peers from a sustainability perspective, has a very strong ESG ratings, but also a very high price multiple versus peers resulting in it being potentially overpriced? In our view, absolutely. In the end, there is no such thing as an ‘ESG aligned’ fund or ESG investing in the first place. There are numerous different ways in which managers can leverage ESG information in their investment processes, and therefore, defining and communicating the intention clearly from the outset is key so that the end consumer is not misled about the investment objective or specific targeted impacts. ESG is a jungle of hundreds of different issues and thousands of metrics, and therefore, anyone using these in the investment process needs to do their homework to ensure that the information used is appropriate and aligned with the investment thesis and objectives of the fund. A good ESG credential thereby depends on the angle of ESG that is being looked at: good risk management, positive impact on specific themes, ESG improvement, etc.? And the integration of ESG information in the investment process needs to align and reflect this view. ESG Osmosis
One of the things that there is agreement around, especially among those of us who have been focused on ESG for many years, is that sooner or later the term ESG will not be used separately. It will simply become embedded as part of sound investment research. So, while the meme highlights the large number of people that have appeared with ESG ‘specialism’ in recent years and even within the past months, what the investment industry needs is two-fold: Investment practitioners who understand the core principles of ESG and integrate those core principles into their investment due diligence practices on a day to day basis. Training, such as the CFA ESG certification or the PRI Academy, is certainly a great starting point, but this does not equate to a ‘specialism’.Depending on the investment thesis, there is the need for individuals who have deep knowledge of specific ESG topics that are relevant for the strategy. Topics like climate change, biodiversity and inequality are incredibly complex, and it may be best to have a research function (whether internal or external) that is specialized in these topics and can support the investment practitioners.
All in all, ESG should not be some specialism that is added on to the end of the investment due diligence process, but rather embedded in the day-to-day investment process that analysts go through when researching investment ideas. Get in touch at info@northpeakadvisory.com if you would like discuss how you can spark lasting change within your firm.