How are investment managers making ESG decisions?
The ESG investment landscape is evolving rapidly from its roots in negative screening. We sat down with Brian Matt, head of strategy and innovation for Corporate Solutions at IHS Markit, formerly Ipreo Corporate Solutions, to find out how investors are thinking about ESG today and how that's quickly changing.
How are investment managers making ESG decisions today?
ESG is the area that is most in flux when we talk to the asset management community - ask just about any manager and you'll find their approach today is different than two years ago, a year ago, even six months ago.
To start with, there's a massive amount of new demand coming in from the asset owner community in portfolios managed with at least some type of ESG overlay. Every time a new pension fund mandate comes up for RFP, for example, asset managers are asked to provide details on not only their pure ESG strategies, but also on how they overlay ESG on their non-dedicated portfolios. Most managers have had pure "primary screener" portfolios in their arsenals for some time, and these are growing in size as well (active ESG portfolios at 5% CAGR in a shrinking broader active market, passive portfolios at 21% CAGR, over the last 4 years). But the real growth we're seeing is in the "secondary screener" or "integration" strategies across the rest of the equity and fixed income universe; these are portfolios that are still primarily making decisions on financial criteria, but then do anything from simply seeking a high average ESG score for portfolio companies, to adding additional ESG screens, to even engaging with portfolio companies to push for changes to how they operate.
Any managers more or less likely to be using ESG across their entire range of portfolios?
There are definitely some rules of thumb there. As a whole, the hedge fund community isn't doing much in this area, though we have seen a few pure play ESG hedge funds set up. A survey of US analysts and PMs we completed earlier this year showed just 42% of hedge funds that we spoke to were integrating ESG in some way, as opposed to 84% of traditional asset managers incorporating ESG. The hedge fund community may get there down the road as they compete for pension fund assets, but for now you're not likely to have a hedge fund analyst ask too many ESG questions.
It probably goes without saying, but European managers tend to be a bit more developed when it comes to using ESG information and having rank-and-file analysts ask questions around ESG characteristics. One way to put it is that it's almost impossible to avoid ESG in a meeting with a European manager of any stripe, whereas it won't always come up in the US. APAC managers are a unique case - there are a few markets there that have specific stewardship codes requiring managers to look at companies on non-financial characteristics. In particular, the exchanges in APAC have been comparatively more progressive in requiring companies to disclose ESG information, so the comparable data sets for portfolios already exist. Expect APAC managers to be involved with ESG, depending on the country and portfolio focus.
How are managers structured to gather ESG information about companies?
Most managers are now intaking one or more ESG data sets on companies today… above a certain size you'll have individuals involved with deciding what data to license, how to store it, and how to merge it with portfolio information. Sometimes that's as simple as saying, "license the data on the terminal, then review it in the terminal's portfolio manager tools" - but there are firms that have built much more comprehensive systems which ingest the data and bring it to decision-makers. So, there's a purely data-centric role at some firms.
The next level up would be dedicated ESG analysts that use the data to make recommendations to analysts and PMs - this is a pretty common structure in larger firms and many European asset managers. The PM can ask the ESG analyst for a deeper review of ESG risks to help them build their investment case. Sometimes this group will overlap with stewardship teams who are in charge of generating the vote recommendation and engagement outreach - most firms need to have at least one well-formed opinion on the "G" in ESG once per year for every portfolio holding to make an effective voting decision, so the stewardship teams already have one leg of the stool complete.
Last, and fastest-growing, would be the rank-and-file analysts that are using ESG data to make decisions on companies. If you look at the growth rates on the major research providers, most of that growth is coming from site licenses to view ESG data and research across the entire equity and credit research operation, and licenses to have all the data available on data terminals alongside all the fundamental analysis. This is where you'll see that question: "I saw you screened low on Social on my terminal, any idea why that is?"… coming from an individual who only spends a small portion of their time on ESG data. I'd say these questions are actually great for companies, as they give an immediate chance to add value. The feedback from the investor community that our team gets: There clearly is more demand to dig deeper on companies, use more granular datasets and be able to compare across companies and frameworks. Data providers have progressed quite a bit here, though the market feedback still is that most asset managers do not fully "trust" the data and use it more as a general benchmark, which then triggers more due diligence when certain shortfalls are alerted, whether it comes to engagement practices of the firm, or also investment decision making. Most investors agree that the market is changing, and what is required and available today will evolve and expand in the next three years and the entire stakeholder group will have to be prepared for that.
What external sources of information is the buy-side using?
There are a few categories of sources to consider here. First are the major research providers - MSCI, Sustainalytics, ISS Oekom, RobecoSAM are probably the largest in terms of those collecting ESG data and providing an analyst opinion and a research report, not just raw data.
There's another set of data providers - maybe group Refinitiv's Asset4, FTSE Russell, and a few others here, that are simply producing an ESG data set without analyst research, but are still collecting data from what companies make public and usually sourcing the original company statements when they're released. We've even seen a few aggregators pop up in this space…I don't know if it'll ever get to a "First Call"-style model like what happened with earnings estimates, but if the data is comparable enough maybe similar happens.
Then, there's a wide range of other focused research providers that focus on one or a few issues, set up a framework for what to collect on this issue, then collect the data and make it available to investors - CDP (Carbon Disclosure Project) is a good example here, but there are plenty of others.
You also can't overlook the ESG-specific indices that are being sold into asset managers, either as a way to replicate an ESG strategy in an ETF, or to exist as a benchmark for an active portfolio. FTSE Russell and MSCI produce a whole range of ESG indices - even if it's not actual ESG data on a company, if you're a portfolio manager benchmarked to an ESG index, you need to know something about all of the securities in the index, as you're essentially making a decision not to own a stock in an index you're looking to outperform.
What internal ESG research are investors conducting on companies?
Beyond the external data sources, analysts and PMs need to do their own homework as well, even if only to stay within their fiduciary duty requirements. You might not even call some of the basic risk management exercises an investor conducts "ESG research" - if you're covering consumer stocks, for example, supply chain is probably a risk for your portfolio companies, so you need to know the environmental and social risk inherent in the supply chain simply to get a clear view of risk. The sector doesn't even matter from a "G" perspective - if the board of a company in your portfolio has a history of poor oversight on cybersecurity, for example, you need to do some research.
One question we get often is "are investors actually reading our sustainability report?" The answer is a little more nuanced - the research providers are "reading" and ingesting the entire report, but very often what we're hearing is a sector analyst seeing a red flag somewhere in the research, then diving into just one section of the sustainability report to do their own investigation. They're not reading it cover-to-cover, but you're never sure which section they'll need to refer back to in order to get the right information. Or, worse, the material risk isn't discussed in the report, so they assume the company doesn't have an answer for it. (So, yes, please keep producing your sustainability reports, and the other suggestion we get is to make them as easy to navigate as possible to save time in finding the information on material issues).
How often are investors pushing for change on ESG at companies?
Moving from research to "active engagement" is something that's becoming much more organized inside the asset manager community. Asset managers pitching a large pension fund on an RFP are generally asked to describe what their engagement process is with each portfolio company, and leaving that blank on the RFP isn't a good move if you want to win the business. Most large asset managers are also UNPRI members, having signed up to follow certain principles, one of which being "proactive in engagement" with the different stakeholder groups.
There's a couple ways for investors to have an impact on the company, and to show that they're looking to have an impact on the company to their asset owner clients. One is the voting process. Most investors are set up to allow the asset owner to vote their own shares, and many will offer a middle ground of a custom voting policy that takes the asset owner's guidelines into account. However, in a commingled investment portfolio the asset manager nearly always keeps the voting rights, but will still want to vote them in the best interests of all the beneficiaries of the portfolio. For this reason, it makes sense to have a voting policy that does put some pressure on companies. For example, many investors will have a standard policy of supporting board declassification proposals if they have large institutional asset owner clients, as that's become fairly common practice in those pension funds' own voting guidelines.
The other is direct engagement - reaching out to the company to discuss a particular issue. The largest asset manager names out there have opened up in the last couple years and become very public about their engagement programs. The best way to start here is to look at what BlackRock and Vanguard are saying. BlackRock published its engagement program stats for 2018 - 2,050 engagements with 1,450 companies, on key issues including board diversity, climate risk, etc. Now, imagine being the asset manager competing with BlackRock for that same piece of business, and you'll get the feel for why asset managers are doing more of this type of engagement in general.
Note that UNPRI Transparency Reports can give a good idea of how active an investor states it intends to be. For your next meeting, go to www.unpri.org, type in the investor name in the search bar, and find the most recent Transparency Report. Section OO-10 has some useful information on the investor's engagement practices, as well as a gauge of how likely an investor is to want to push your management on a non-financial topic.
How can companies maximize their placement in ESG portfolios?
The reality is that the vast majority of assets integrating ESG are conducting a "negative screen" - i.e. screening out securities whose companies rank poorly on screens. However, the asset growth is so rapid, and the research sources so diverse, that putting in additional effort on ESG is not a zero-sum game. We like to split this into an operational aspect and a communications aspect.
The operational side builds up from the materiality exercise that, really, any company should conduct. Each company involved in each industry should have a set of ESG values that are the most material to that industry. No matter what, every company - even if they don't disclose it at all - should endeavor to go through this exercise.
After that, there are values that are measured by the most influential research providers, as well as some of the larger NGOs. The next step is to look at the company's existing placement (most providers will share a copy of the existing research) and look at how to report values that will be industry-comparable and help produce a stronger result in each category. A warning - there are diminishing returns to this process…there are a lot more research providers out there than you have time to communicate with - but your investors will usually tell you the providers that they're using to make decisions, which helps you prioritize your time.
For many companies, the communications aspect is fairly simple - there are screeners that simply record disclosure vs. lack of disclosure, and rate a company on their overall disclosure level, with a poor rating in one category better than no rating at all. Simply publishing a sustainability report with material information for the company, and collecting the necessary information to have that report publishable, helps a company clear that low bar relative to others.
In this scenario, the communications process becomes one of highlighting progress within the company, as well as highlighting material areas for the business in easily-digestible form. There's a lot of different approaches here - we like to think of fitting these to the different investment constituencies, including not just the researcher for an ESG provider, but also the fundamental analyst or PM. They've told us many times that they want to hear both the positives as well as the negatives on material issues, since they do see it as valuable to intersperse material ESG progress with the investment story. Some companies go as far as to set goals for themselves to be able to show progress against targets. While that may not be appropriate for every company, the goal of investor communication is to build trust - and ESG is another opportunity for the company to do so.
At the other end of the spectrum, we've also seen companies use shoe leather, not just pixels, to tell their ESG story - we've seen an increasing number of companies spend time out on the road meeting with ESG-focused contacts on the buy-side, both gathering feedback as to what information they're looking for as well as reinforcing the story.
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