It pays to do the right thing

ESG is a source of alpha – with the right approach: Morningstar Executive Forum

Ruth Saldanha 7 March, 2019 | 9:36PM

Sustainable investing. Responsible investing. ESG (environmental, social and governance) investing. Call it what you will, but it’s here to stay. And it’s picking up steam and going mainstream, a Morningstar Canada forum on ESG investing was told.

The Feb. 27 Morningstar Executive Forum focused on ESG in terms of active versus passive investing, advocacy within companies by investors, the role of ESG factors in developed versus emerging markets, and ESG as a source of alpha.

Three panelists spoke at the forum – John Hale, Morningstar’s global head of sustainable investing research, Jeremy Peng, VP of investments and portfolio manager at NEI investments, and Judy Cotte, founder and CEO of ESG Global Advisors. The panel was moderated by Michael Keaveney, director of investment management at Morningstar Associates.

Peng started off the discussion by noting that ESG needs to be seen as a factor in itself in investment screens.

He also pointed out that of the three pillars - environmental, social and governance – governance is the strongest. Cotte agreed, adding that governance stands first, followed by social and finally environment.

However, Hale warned that ESG should not be fundamentally broken down by pillars as they're not one-size-fits all - not all pillars may apply to a company. 

“Increasingly, we are seeing the term “Materiality” used to judge a company’s sustainability, which relies on factors and indicators that are material to a company, and depends on the company’s business,” Hale said.

You need to actively look for ESG

This reading of ESG parameters based on attributes material to each company’s business, opens the door for active management within the ESG theme, and one of the early themes the panelists touched on was on active versus passive management. As we noted last month, ESG mutual funds have been around for more than a decade, but ESG exchange traded funds are relatively recent. The panelists were near unanimous that ESG themes are better off being active managed.

Hale pointed that that using ESG in a passive strategy is taking advantage of a quality index. “The creators of these indexes try to keep tracking error low, and not perform a way too different from the index, so these strategies do not consider ESG momentum as a factor. Frankly the data generated is meant to help active manages handle ESG related issues – not passive managers”, he said.

Cotte added that ESG scores and data are better suited to screen out the worst performers on the ESG parameters, rather than pick the best. “To generate alpha, you need sector specialists who can gauge impacts on eventual valuations, the industry and other things,” she said, adding that there is closest correlation between performance and ESG momentum – which means the best returns are from not those that score the highest, but those that are doing the most to change in line with ESG goals.

ESG alpha needs long term engagement 

Which then lead to the question, should investors chase alpha, or invest purely based on ESG values? Peng notes that ESG by nature is longer term, while alpha is more short-term. Put another way, ESG values could be aligned with alpha, it is just that the timing might not be perfectly aligned in the immediate term.

“When chasing alpha, one might ask, ‘Can the company generate returns higher than the cost of capital?’. With ESG values, one would add just one word and ask, ‘Can the company sustainably generate returns higher than the cost of capital?,” Peng said.

ESG is often value based, and in those circumstances, client preferences are key. Especially when it comes to divestment versus engagement. There was consensus on the panel that in terms of delivering overall value, engagement is the way to go. But clients may not always agree.

“Divestment is a personal and political choice, if clients want to divest out of a sector, or out of a company, it is the way they want it. But if responsible investors divest out of a sector or company, other investors who don’t have the same thought process will be able to buy the stake, sometimes at a discount. So nothing changes, it is essentially a wealth transfer from one investor to another”, Cotte said, pointing out that it is far better for investors to use capital power to engage with companies.

Hale argues that engagement is more productive. “Companies are increasingly being engaged with, and so have to address investor concerns. It is equally important that companies realize that this engagement need not be an adversarial relationship between them and some investors, but better for the business as a whole,” he says.

Cotte notes that there is some criticism of engagement, mainly that it’s a lot of talking and talking doesn’t get much done. “However, shareholders have levers of power beyond talk – proxy voting and shareholder proposals – to drive change when companies are reluctant,” she says.

With more companies aligning with ESG themes, and engaging with shareholders, consumers, investors and the work force, are opportunities shrinking or expanding? The answer is both.

“As managers focus more on ESG, efficiencies improve, and ESG scores get priced into the share price. But the good thing is that new data sets emerge that keep highlighting different inefficiencies. Both things are happening simultaneously,” Peng says.

You need the right data to do the right thing

“Managers are swimming in data – but is it the right data? That’s what generates alpha for active managers,” Hale says.

Cotte points out that ESG data is in a nascent stage. “In our talks with managers and investors, we find that managers have 25% of the data they need for the environmental and social pillars, but about 90% of the data they need for governance. The point is, new data is always being generated, and that creates new opportunities.”

Finally one accusation levied against ESG data is that it biased against large cap companies, which leaves out portions of the market, especially emerging markets.

And Peng says that when it comes to emerging markets, theoretically, efficiencies should be higher but the problem is that the data quality isn’t there.

“For instance, what factors are rewarded by the market? Governance might be, but environmental and social parameters might not. I think the point is that as active managers, we cannot blindly apply the same rationales that we use for developed markets to emerging markets,” he says.

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Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca