Closing the gap in responsible investing

This article appears courtesy of Global Investor

In many board rooms, discussions of Responsible Investing (RI) still focus on it as a mythical one-horse show—a perceived investment practice that must automatically limit the investment universe and thereby limit returns.

Over time, this perception is breaking down. In fact, an even larger number of pension committees now sit in board rooms to consider the merits rather than the limits of integrating environmental, social and governance (ESG) factors within investment processes.

By now, this group of forward-looking trustees knows that those increasingly familiar initials —RI, ESG—potentially relate not only to social conscience but also to improved investment performance and better risk management, though it has taken some doing to get to this point. October 2007 saw the publication of Demystifying Responsible Investment Performance, a joint report by the Asset Management Working Group of the United Nations Environment Programme Finance Initiative (AMWG UNEP FI) and Mercer.

Highlighting academic research examining the relationship between ESG issues and financial performance, the report helped to dispel the preconception that integrating ESG factors into investment analysis and decision-making automatically leads to financial underperformance (the majority of studies reviewed displayed a positive or neutral impact).

Since then, the debate about ESG factors and investment performance has intensified, due in part to changes in regulatory standards (especially related to climate change and corporate governance), new corporate disclosure guidelines for ESG factors, and the large number of new signatories to the Principles for Responsible Investment (PRI) initiative, which seeks to integrate ESG factors into investment processes for both asset managers and asset owners. As the importance of ESG becomes more evident, investors are increasingly asking how fund managers are considering these issues.

Clearly, more evidence can only help, and so a Mercer follow-up study, Shedding Light on Responsible Investment: Approaches, Returns and Impacts, summarizes some of the new academic studies released since the 2007 joint report. The new report reviews 16 academic studies that focus on the link between E, S or G factors and firm or portfolio performance.

The studies review performance over a variety of time periods and draw from a number of well respected sources. Once again the research weighs against the belief that RI – which we define as integrating ESG into investment decision-making and active ownership – necessarily limits returns. Before we focus on some specific studies, though, consider the broad findings. The results from the recent study as well as the 2007 version are outlined in the table below:

Table 1 – Summary of academic research on link between ESG factors and financial performance

But these statistics only go so far in prompting conclusions, since a variety of measures, such as manager skill, investment style and time period, is integral to how ESG factors translate into investment performance. Therefore, it is hardly a given that taking ESG factors into account will have a uniform impact on portfolio performance; in fact, significant variation across strategies is to be expected.

Investment managers integrate ESG factors into their decision-making process in a variety of ways. The aforementioned PRI initiative provides a forum where signatories can discuss best practice and sources of interesting ESG-related information. ESG integration tools and processes will vary throughout the investment management industry, just as general tools and processes vary.

A Broader Practice

Responsible Investment is not a superficial vetting of a given stock’s social responsibility quotient so much as a broader practice that relies on the often intangible aspects of manager skill as well as the objective power of a number of tools available for integrating ESG into the investment process.

Like traditional factors that impact corporate value, some ESG factors are quantitative in nature, while others are qualitative. Investment managers are already equipped with the skills to evaluate the impact of qualitative factors on corporate value— they often consider brand value, reputation, innovation, intellectual capital, and regulatory risk across a variety of sectors.

One way that investment managers can begin the process of ESG integration is by assessing and comparing the information in corporations’ sustainability or CSR reports and determining how that information best fits into their decision-making process. Bloomberg presents another information source, providing four templates dedicated to ESG data which display a range of numerical and qualitative data – from emissions and energy consumption to human rights policies and size of the board of directors.

In addition to providing a steer on engagement issues with invested-in companies, another method for integrating ESG factors into the decision-making process is using them to enhance valuation models. The Discounted Cash Flow (DCF) model is an ideal instrument because its cause-and-effect-driven structure is designed to build on both quantitative and qualitative assumptions. Using ESG information, which often deals with long-term issues and objectives, could help investment managers lengthen the explicit forecast period and, potentially, the accuracy of the model.

For example, to enhance DCF models with ESG information, investment managers could compare competing corporations’ approaches to improve ESG performance as a possible input into assessing competitive advantage and revenue growth, or evaluate exposure to carbon legislation or pending regulatory changes in the shift to a low carbon economy to adjust operating costs and/or revenue growth.

Using a DCF model to capture assumptions about ESG factors is just one of many approaches to ESG integration. Throughout the field, approaches to integration vary across investment managers and specific strategies. While this discussion has focused on listed equity, there is a growing focus on mechanisms for integrating ESG factors across a range of asset classes such as fixed income, private equity, real estate and infrastructure.

A challenge to this type of integration is the reality that, globally, corporations are not uniformly disclosing comprehensive information about ESG factors, particularly small and mid cap companies. We also know that there is demand for this information from investors. For example, in the 2009 PRI Report on Progress (available at www.unpri.org/report09), we saw that approximately 70% of PRI signatories have asked both for standalone CSR or sustainability reports as well as for inclusion of ESG issues in the reports a company already produces. Other ESG reporting formats requested by signatories include the Carbon Disclosure Project, Global Reporting Initiative, the UN Global Compact, the Extractive Industries Transparency Initiative and CERES.

This lack of consistent disclosure has led to increased utilisation of specialist ESG research services and brokerage reports. Indeed, many of the academic studies also relied on testing the significance of the ESG factors, as compiled by specialist firms. Over time, comparable and reliable reporting standards on ESG factors will be vital to the mainstreaming of ESG integration. Uniform public disclosure of corporate ESG data will also assist academics and researchers in considering a variety of ESG factors as investment drivers that can affect returns.

Studying E, S and G

It is important to note that, depending on the sectors studied, the results of the academic tests related to ESG materiality vary significantly. Thus, results at the aggregate (macro) level may be misleading, as the impact of ESG factors often varies across sectors. The implication is that research and the integration of ESG into investment processes need to be measured and conducted at the disaggregated level, as far as practicable.

In addition, most of the studies to date focus on the link between ESG and listed equity investments, with little research on other asset classes (although this is beginning to change).

Here, then, is an overview of the studies noted in the Shedding Light report for each of the E, S and G factors, affording some specific conclusions (for clarity, we have omitted the titles and authors of the specific academic studies, but these are available by visiting https://www.mercer.com/ri, where readers may access more information from the report):

Environmental

Four academic studies measured the impact of environmental factors on financial performance. One found that the environmental “riskiness” of portfolios has no statistically significant impact on returns, while another, in contrast, found a significant positive relationship between environmental performance and the intangible asset value of publicly traded firms in the S&P 500.

A third study found that the effect of environmental performance on market value is stronger in low-risk industries than in high-risk industries. The fourth examined the issue from a slightly different angle, looking at the provision of environmental information in financial research reports, and found that only 35 percent of financial analysts’ reports in Europe and North America contained environmental information and that the degree of research intensity varied across sectors.

Social

Four academic studies measured the impact of social factors on financial performance. One approached the link between social factors and financial performance by looking specifically at racial diversity and found that this social factor can positively affect firms’ intermediate and long-term financial performance.

A second study showed that employee satisfaction is positively correlated with stock performance, that the market may not fully value intangibles, and that certain investment screens linked to employee satisfaction may lead to outperformance. Finally, looking at social factors through the lens of microfinance, two studies concluded that adding microfinance investment funds to a portfolio can improve returns.

Corporate governance

Four academic studies measured the impact of governance factors on financial performance. One concluded that, for the average firm in the study sample, the costs of implementing corporate governance mechanisms were lower than the benefits. Three of the governance studies found that engagement is positively related to financial health or financial performance.

One of those three concluded that restricted shareholder rights are related to higher debt ratios in most industries. Another found a correlation between the participation of public pension funds and positive results in terms of settlement outcomes, attorney effort, or attorneys’ fee requests or awards. The third study found that the market believes that activism creates shareholder value, that other activists are marginally more successful in their aggressive activism campaigns than hedge funds, and that the market is able to differentiate between overall successful and unsuccessful campaigns.

In compiling some of this latest research on ESG materiality for firm and portfolio performance, we focused particularly on thematic E, S or G impacts more so than the impact of negative screening. If anything, the results highlighted in Shedding Light on Responsible Investment lean in favour of the value-added proposition of ESG integration, and it is encouraging to see more research considering the impacts across different asset classes—that is, beyond equities—and the effects at the disaggregated level, such as sector impacts.

Looking ahead

The growing body of academic and industry research in this field demands careful, discerning study—and that’s not all. Efforts must be supported to evolve education standards and textbook content, both at the professional level for those in the finance industry (such as CFA qualifications) and in relevant academic degree programs. While some graduate programs do exist in this field, globally there remains a lot of work to be done to this end.

Eventually, we envision that investment managers of the future should be well-equipped to integrate ESG factors into their core activities. Those that figure out how to do so in the short term may gain a leg up over the competition.

By Jane Ambachtsheer leads Mercer’s global responsible investment business and Katherine Burstein is an Analyst in the group.