There are four distinct ways to approach ESG investing in systematic investment strategies. Understanding the pros and cons of each can help to align client preferences.
How investment managers and asset owners apply and implement their Environmental, Social and Governance thinking really matters to client outcomes.
Some funds will screen companies for inclusion or exclusion, while others will be willing to buy into (otherwise desirable) ESG laggards but will engage with them to influence change. Meanwhile, some funds will construct portfolios according to ESG benchmarks; others will step away from benchmark weightings to back companies they believe to exhibit favourable ESG qualities.
Each of these different approaches will result in a wide range of risk and return outcomes – even though they all fall under the umbrella of ESG investing.
For instance, a portfolio that excluded carbon intensive stocks based on ESG values and principles in the last 12 months would have likely underperformed portfolios that maintained exposure to these stocks. These stocks have run hard due to inflation expectations and oil and gas shortages from the Russia-Ukraine conflict1.
Australia’s Whitehaven Coal*, for example, might be a natural exclusion for some ESG-focused managers. Whitehaven was up almost 300% in the 12 months to August 2022. Excluding Whitehaven from an ASX200 benchmark-aware portfolio would now constitute at 29bps underweight (it was 10bps 12 months ago). This is a noticeable alpha drag (around 30bps) from just one stock2.
Some investment managers and asset owners might choose to adjust exposure according to a factor – such as revenue from coal-fired power extraction or generation, or carbon intensity – thereby increasing or reducing stock weightings proportionate to their benchmark weighting. This kind of approach can reduce exposure to certain factors, while still maintaining an overall benchmark exposure and keeping the door open for engagement.
Then there are some managers and asset owners that will look at ESG qualities as a source of alpha generation and invest accordingly. Integrating ESG in this way could mean gaining exposure to companies that share particular attributes or beliefs.
Categorising the different approaches to ESG investing is one thing, matching them to client preferences is another entirely.
Our analysis, The four building blocks: ESG in systematic Investment Strategies, outlines the strengths and weaknesses of each approach to help align with client preferences.
Exclusions might test a client’s appetite for trading off returns against ESG issues and tolerance of tracking error, for instance.
Separately, funds seeking outperformance by investing in companies with positive ESG attributes might need to build a strong case through performance analysis or find clients with aligned views.
The four approaches to ESG investing and their respective pros and cons, include:
1. Universe construction, through negative or positive screening.
Simple and clear definition. Markedly changes ability to engage. Adds tracking error.
2. Risk factor control.
Definition of measured factor needs to be suitable. Potential for tracking error increase. Clear measurement of effectiveness
3. Alpha sources
Data consistency and history is important. Insight can be very additive as it is not well explored
4. Engagement and stewardship
Can see change over time. Can directly influence management and board. Has lower breadth but greater depth of engagement.
* This stock information does not constitute any offer or inducement to enter into any investment activity.
1 This is clearly a short term effect: longer term we (and most others) expect to be rewarded by a tilt away from negative ESG stocks.
2 Factset, Realindex, August 2022
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