In 2004, then UN Secretary-General, Kofi Annan, wrote to the CEO's of significant financial institutions and a group of the world's largest institutional investors to ask them to take part in an initiative to integrate Environmental, Social and Governance (ESG) practices into capital markets.
An investor group from a variety of countries, comprising experts from both public and private sectors, came together to launch the Principles of Responsible Investments (PRI) at the New York Stock Exchange in April 2006. This provided a global framework of six main principles for investors to consider in the incorporation of ESG issues into investment analysis and decision-making processes. The aftermath of the financial crisis in 2008/2009 saw an increased level of participation in the PRI as an improvement in governance was viewed as systemically important. In the subsequent years, as energy sources have shifted and climate change has become more universally acknowledged, ESG and sustainable investing is a growing priority for asset managers. Since April 2006, the number of PRI signatories has grown from 100 to over 2,300 in November 2019.
Sustainable investment asset levels and terminology
According to the Global Sustainable Investment Alliance, sustainable investing assets in the five major markets stood at $30.7 trillion at the start of 2018, a 34% increase in two years since the previous report in 2016. With this in mind, the objective of this article is to firstly discuss the trends we are seeing among fund groups who are launching and marketing these strategies and secondly, to assess the challenges they face in their investment analysis and portfolio construction. Before this however, it is important to note that there are various terms used interchangeably between investors to cover a wide spectrum of goals and strategies. This includes Sustainable Investing, ESG Investing, Socially Responsible Investing (SRI) and Impact Investing to name a few. While the focus of this article isn't to distinguish between these subsets, it does highlight the challenge that advisers now face in selecting, from an increasingly wide range of strategies, the appropriate funds to meet their client demands.
Sustainability strategies and integration levels
Despite the increasing number of industry organisations and initiatives, the lack of standardisation and transparency in ESG reporting still presents major challenges for investors.
Having launched our SRI rating service back in 2007, the investment team at RSMR meet on a monthly basis to discuss the broad trends among fund groups who are launching and marketing these strategies. With an increasing number of sustainability strategies now available to retail investors, we seek to identify and assess the level of integration that a fund group offers in its approach. To illustrate an example of this analysis, while focusing on ESG integration, we believe that there are three overarching categories that fund groups typically fall into. The first of these are fund groups which are at the early stages of adopting ESG practices into their investment process. These fund groups will typically use third party research firms to provide ESG scores for the underlying investment universe or will implement negative/exclusionary screening to an existing investment process. The second grouping tends to be fund groups which are further along in implementing ESG practices and have invested more resources into their process. These fund groups have a small segregated internal ESG research team who will conduct their own analysis separately to the wider investment platform. The final grouping is fund groups demonstrating company-wide integration between ESG and fundamental research. As a fully integrated platform can take years to build, we are finding that more and more newer funds are falling into categories one and two, making it increasingly important for fund selectors and advisers to understand how these fund managers approach portfolio construction.
Standardisation and transparency in ESG reporting
Despite the increasing number of industry organisations and initiatives, the lack of standardisation and transparency in ESG reporting still presents major challenges for investors. Whilst third party ESG providers play an important role, there are limitations to the data whereby different methodologies and weighting systems lead to wide dispersions in ESG company rankings. This results in companies being included in some sustainability funds and excluded from others. A number of fund groups in categories two and three have designed their own sustainability ranking and scoring systems to manage this. Again, this leads to further subjectivity whereby a company may score highly on an overall ESG metric with one fund group and receive a lower score with another fund group. We encountered a recent example of this with Unilever, where one fund group had assigned the company their top ESG rating but another had excluded it from their fund due to the company's involvement in non-medical animal testing. The same situation occurred for Ecolab, the global provider of water, hygiene and energy technologies.
Methodology and subjectivity
According to the Global Initiative for Sustainability Ratings, there are now more than 125 ESG data providers with the most well-known including Bloomberg, FTSE, MSCI, Sustainalytics and Thomson Reuters. There are fund groups with fully integrated ESG analyst platforms that have designed their own methodologies for ranking companies. Despite these positive developments in recent years, investors must remain cognisant that a high level of subjectivity remains within these strategies and it is vital that the adviser understands exactly how fund managers within this space select their underlying securities and construct their portfolios.
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