7 questions for assessing ESG expertise

Asking these questions about sustainable strategies will get you a step ahead of most investors.  

Benjamin Joseph, CAIA 28 July, 2020 | 1:09AM
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There is no one correct approach to run a sustainable strategy. Environmental, social, and governance criteria are used in a variety of ways by asset managers, and from ESG consideration funds to impact funds, the spectrum is wide.

Navigating the universe of ESG strategies is a daunting task, but you can start sorting the wheat from the chaff by asking these seven questions.

1) Do ESG criteria help frame the strategy's investment universe?
The first step of ESG integration in an investment process is typically some sort of exclusionary screening of securities deemed incompatible with the sustainable mandate. These ESG screens can be evaluated based on their depth and dynamism.

The depth is defined by the level at which the screens are applied. First, many but not all ESG integration strategies use blanket exclusions for certain sectors, businesses, or products, such as tobacco, guns, coal, or all fossil fuels.

Second, most ESG integration strategies use ESG evaluations of individual companies to narrow the investable universe. The degree to which ESG evaluations do so varies.

Dynamism refers to the frequency with which the investment universe is filtered through the screens. Exclusionary screens are typically set once, while dynamic screens continuously monitor ESG criteria leading to a fluid investment universe that reflects companies' sustainability efforts or lack thereof.

In addition to assessing the nature of the screens, it is important to question managers on whether there are exceptions that allow them to invest out of the set universe, and if so, on what basis.

2) How do ESG criteria impact investment decisions and portfolio construction?
The most comprehensive ESG approaches run through all security-selection, position-sizing, and sector-allocation decisions in addition to using a defined ESG universe based on the screening processes described above. 

Some approaches are less integrated. For instance, ESG criteria may be used to define the investable universe, but actual security selection, sizing decisions, and sector allocations proceed just as they would with a conventional strategy with no further ESG evaluations. On the other hand, some strategies consider ESG criteria in every security-selection, position-sizing, and allocation decision but do not rely on screens to narrow the investable universe.

Finally, ESG consideration approaches are those that refer to ESG criteria in their prospectuses as factors that are considered in their investment process. Managers retain complete freedom to consider ESG factors whenever they deem relevant, which often results in a portfolio where financial criteria dominate sustainability inputs.

Ultimately, identifying how ESG criteria are integrated in investment decisions is key, as holdings analysis alone is a weak indicator of the strength of a sustainable process.

3) How do ESG metrics impact the strategy's risk management?
ESG-integrated risk management varies meaningfully, from consultative dashboards to comprehensive processes aimed at mitigating ESG risks embedded in a portfolio. The lack of ESG risk metrics on post-investment decisions is a common weakness across ESG processes that give managers the latitude to overlook an increase in ESG risk in favour of financial prospects.

Assessing the ESG risk-monitoring process and the managers' discretion is key. Strong ESG integration at the risk-management level implies automatic actions when ESG metrics deteriorate. Depending on the situation, it could lead the manager to engage with the company, decrease exposure to the security in question, or divest entirely.

4) What is the engagement and proxy voting strategy?
ESG engagement encompasses all forms of direct communication between investors and companies on environmental, social, and governance matters. ESG engagement may also include broader actions, such as collaboration between investors, industry experts, and companies.

When engagement fails to produce the results sought by ESG managers, they may register their disapproval in the proxy voting process by proposing or co-sponsoring shareholder resolutions on contested topics, voting in favour of such resolutions, or voting against board members.

A comprehensive engagement strategy is a critical component of a sustainable investment process because it allows the asset manager to gain insights into how businesses cope with various ESG risks and opportunities, while also encouraging issuers to improve their ESG profiles or reduce their ESG risks.

5) Does the parent company have an ESG team?
As ESG efforts are typically resource intensive, management companies committed to deploying ESG analysis across their offerings generally build a centralized and dedicated ESG team with expertise in key issue areas. This setup usually leads to a sizable and experienced ESG team. On the other hand, some firms decide to train their generalist research teams. While raising the ESG expertise of analysts and managers to a satisfying level may take time, this favours effective integration.

Ultimately, it is critical to evaluate an ESG team's proximity to the investment process. Indeed, a large and seasoned ESG team that has little direct connection with a strategy's investment decisions may not be as effective as a small ESG team that works directly with a strategy's managers. An asset manager's ESG resources may be vast but end up only supporting the firm's ESG engagement and marketing efforts if they are disconnected from investment strategies.

6) How does the strategy leverage ESG data?
While the quantity, quality, and diversity of ESG data collected or sourced from third-party providers are obviously important parameters, the way this data informs the research process and impacts investment decisions is a key differentiator between basic ESG efforts and sustainable investing leaders.

The quality ESG resources is proportionate to a team's ability to compile the multiple data sources and build the proprietary ESG models that establish robust analytical frameworks. 

7) How ingrained are ESG principles in the company's operations?
When looking at asset managers, investors need to go beyond the resources spent to grow dedicated teams and data collection efforts. Many management companies flex marketing muscles to capture growing investor interest in sustainable investments. But only a few can claim to be making the best use of these and demonstrate tangible achievements on topics like diversity, executive compensation, and climate change. To do so, management companies must provide full transparency on both internal policies and proxy votes as well as comprehensive reporting of their efforts.

Selecting an ESG investment requires an extra layer of due diligence because of the range of approaches applied across asset classes and across active and passive strategies. Strong sustainable strategies share common features that can be unpacked by analysing three key dimensions: investment process, ESG resources, and parent company philosophy. While each dimension plays a part, the process is the key differentiator, and a comprehensive engagement strategy is a critical enhancement to this process.

Sustainable investing processes are resource-intensive, and investors should keep in mind that some portfolio managers might not actually use the available ESG resources, which only serve firmwide marketing purposes. Many asset managers have made commitments to build their ESG efforts, but they should be evaluated on their present results.

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About Author

Benjamin Joseph, CAIA  Benjamin Joseph is a Manager of Research for Morningstar and Chartered Alternative Investment Analyst.

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