3 ESG investment strategies: passive, integrated and active

Of the three, the integrated strategy offers the best of both worlds – superior ESG rating and better financial performance, finds a PWL Capital study

Yan Barcelo 6 February, 2019 | 6:00PM

In ESG investing (Environment – Social – Governance) a large majority of investors are – unknowingly – passive. An increasing number adopt an “integrated” stance. Very few are “active”. Those are the three categories with which ESG ETFs can be analysed and selected according to the recent Guide to Responsible Investing – Doing Well by Doing Good, written by Raymond Kerzerho, Peter Guay and Marc Brodeur-Béliveau of PWL Capital.

“Prevailing trends are favorable to ESG funds”, says Raymond Kerzérho, director of research at PWL Capital in Montreal. Numbers bear him out: Canada stands as a world leader with more than $1.5 billion ESG assets under management.

The authors examine each investment approach, and along the way, explain the false ideas and misunderstandings that have lead many to believe that ESG funds deliver inferior returns compared to traditional funds.

For the passive investment approach, returns trump ESG considerations. The manufacturers of such ETFs, like BlackRock, State Street and others, call on advisors, usually external and independent, to choose the assets that will make up the fund. Furthermore, calling on their major shareholder powers, they strive “to have discussions with boards and management so as to improve ESG profiles of companies in areas that could potentially have negative risk/return impacts on shareholders,” write the PWL authors.

In truth, the passive approach is commonly used by an increasing number of portfolio managers, who don’t advertise it as such, but try to avoid shocks and public outcries that could result from catastrophes like oil spills or the discovery that a company resorts to child labor.

In the integrated approach, investors give equal weighting to a fund’s ESG profile and its risk/return profile. Consequently, stock selection is very exhaustive and follows quantitative criteria set up by third party specialists, like MSCI. This firm weighs in with 37 key performance indicators informed by data supplied by more than 185 research analysts that scour the data bases of NGOs and international organizations. It then assigns a rating to the companies analysed.

“The aim is to rebalance a portfolio so as to skew it towards high scoring firms,” notes the study. The purpose is not so much to avoid bad ESG players, as to choose those that present the best ESG footprint. MSCI has even incorporated an ESG momentum factor that tracks the change in ESG rating of companies, and accordingly increases or decreases the weighting of companies in the portfolio that show an improving or a deteriorating ESG score – thus promoting change.

An active approach gives precedence to ESG factors above the risk/return profile of a fund. We could talk here of “impact” investment that seeks to effect specific changes in organizations, for example gender diversity or improved conditions for workers.

“Increasing the flow of capital to investment strategies that generate a financial return while intentionally improving social and environmental conditions will benefit all of us,” insists Loren Francis, vice-president and principal with Highview Financial Group, in Toronto, and a proponent of “impact” investment. “We need to reconnect company success with social progress and bring business and society back together.”

“It now seems clear that the three strategies analyzed have very different impacts on the financial performance of a portfolio,” states the PWL Capital study. For example, the passive approach “should not have any significant impact on the risk/return profiles of a portfolio”. On the other hand, an active approach can result in lower returns says Kerzerho, though he prefers to hold back judgment since “the sector, he comments, has still so limited a scope that it is difficult to document and identify its performance.”

The PWL study definitely favors the integrated strategy, especially since a 2015 research “suggests that a better ESG classification may lead to better financial performance. That is promising for a field with increasing assets under management and better information disclosure and research.” It’s the best of both worlds: a superior ESG rating and better financial performance.

In distinction from the two other approaches, the integrated one does not exclude any single asset. It accepts all types of industries, as long as the company treads the right path. Those stocks that show a poor ESG performance are under-weighted, those with superior ESG performance, over-weighted.

A long-time practitioner of ETFs and of ESG investment, and a portfolio manager at Desjardins Gestion de patrimoine, Mary Hagerman is comfortable with PWL Capital’s three categories and also gives her preference to the integrated approach.

“My interest in ETFs comes from the fact that I want the least emotion possible in the investment process,” she says. “Where you don’t have a process with strict rules, you open yourself up to managers’ mistakes. That’s why I also think that the integrated strategy, which follows strict rules, is the best one.”

However, she considers the PWL study a work in progress because it doesn’t take into account, for example, a risk factor analysis, a leading-edge approach that Desjardins’ recent launch of eight ESG ETFs adopts. For Hagerman, Desjardins’ offer is constantly improving, to such an extent that she now considers proposing to her clients a 100% ESG ETF portfolio.

About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, writing for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.