Fund Investing

Managers employ ESG analysis to reduce risk and uncover opportunities.
By Michael Ryval | 07/11/16

Investing according to environmental, social and governance (ESG) principles has evolved over time to become increasingly proactive. Back in the 1990s, it was known as socially responsible investing, or SRI, and tended to focus on excluding certain kinds of companies. Over the past several decades, ESG has broadened its reach so that investment managers have the tools to construct better portfolios, as well as influence the behaviour of the companies they own.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"We have seen quite an evolution from SRI to ESG," said Shila Wattamwar, associate director, advisory services for New York-based Sustainalytics, a consulting firm. She was one of three panelists who participated in an Executive Forum held at Morningstar's Toronto office on Nov. 2. The forum was moderated by Jon Hale, Morningstar's Chicago-based head of sustainability research, and attended by about 80 industry executives.

"SRI was traditionally looked at as a values-based investing option," continued Wattamwar, whose firm provides ESG research services and support in implementing ESG principles. "People used exclusionary screens and looked at excluding tobacco firms, for instance. ESG does encompass values-based investing, but it can also look at stocks with a risk or financial lens. People are integrating it into an investment portfolio, either because they want to focus on certain impact-based areas, or they want to integrate ESG into their mainstream portfolios as a way to look at additional factors with regards to risk."

ESG has been a reality for three decades, according to Daniel Solomon, senior vice-president and chief investment officer of Toronto-based NEI Investments, which has $6 billion under management. NEI's offerings include the Ethical family of mutual funds, the oldest of its kind in Canada.

"For us, ESG investing is about making the right decision when you invest in a stock or a bond. Essentially, you look at all aspects of the company. I don't see this as revolutionary, but good common sense," said Solomon. "To us, ESG means the inclusion of various factors in making a better decision about companies. We will ask: What are the environmental risks assumed by your firm? What about your labour and social relations and supply-chain management? What about your corporate governance? That's the easiest one, and most traditional one which most people are looking at. In the long term, the financial prospects of a company can be influenced negatively, or positively, by the factors we have outlined."

Reflecting the growing acceptance of ESG, it has been embraced by RBC Global Asset Management Inc. (RBC GAM), the largest private-sector asset manager in Canada with $385 billion under management and offices around the world. "We are about three and a half years into a comprehensive program of integrating ESG for exactly those reasons," said Judy Cotte, vice-president and head of corporate governance and responsible investment and formerly chief operating officer of the Canadian Coalition for Good Governance. "We really see these factors as alpha-generating potential and a great tool to mitigate risk."

Indeed, Cotte added that RBC GAM's portfolio managers are particularly interested in the way that ESG uncovers opportunities. "How can looking at these non-traditional factors help you outperform in the future as regulation intensifies and consumer preferences change? It's the opportunity side that gets portfolio managers excited."

Because ESG requires a lot of work and nuanced understanding of complex factors to assess companies, Cotte added that "it really is a tool to help managers to outperform the market, and of course, identify risks in their portfolios."

The widespread availability of data has helped ESG gain more ground, said Wattamwar. "There is just more data available, which lends itself to greater quality. With more standardized reports, the interpretation of the data becomes more objective and insights become more meaningful. We have also seen a big uptick in the tools and solutions available to our clients. They can see the linkage between ESG factors and other valuation tools. These trends have driven ESG usage within many investment processes."

Significantly, at RBC GAM, each of its 23 teams around the world, in locations such as London and Hong Kong, has a free hand to apply ESG as they see fit. "But it works for each of them," says Cotte. "Our requirement is to develop a way to integrate ESG within the process in a way they believe adds value. They have to be systematic about it. But we're not telling them how to go about it. It really depends on the mandate and the asset class."

For instance, Cotte noted, the emerging-market sovereign debt team in London had always considered governance and social factors in their analysis, yet it had ignored environmental factors. "They looked back 10 years and did a regression analysis to figure out which environmental factors are correlated to bond prices and risk, and managed to identify seven factors. They have now built those factors into their global fundamental model of risk and pricing," said Cotte. "Allowing each team to develop a process can spark innovation and do it in a way that adds value."

There is no doubt, however, that adhering to ESG principles means going beyond conventional investment research. At NEI, Solomon noted that ESG means conducting extensive internal research and company interviews. "We have been engaging companies for years and do it in a very dedicated and shareholder-focused way," said Solomon. "It requires a lot of work to engage boards. And we need a lot of expertise in how to use our shareholder votes, and our ownership, to be able to achieve progress. We have a saying, ‘You can't change a company that you don't own.' Negative screening does not achieve much. You need to work with boards."

To complicate matters, NEI has 16 sub-advisors, and that means tailoring ESG to each mandate, asset class and investment style. "We do ensure that there is uniformity, in terms of how ESG factors are applied and how evaluations are conducted," said Solomon. NEI has an eight-person ESG team which ensures that ESG principles are applied consistently. "We vote all our proxies and we conduct all of our engagements."

NEI has partnered with sub-advisors, such as London, England-based Hermes Investment Management, to achieve bigger positive changes by combining all their proxy votes in order to make corporate boards pay attention. "But we do it from the perspective of making more money, not for ideological reasons. We do it more as shareholders who are concerned about sustainability in the long run and ensuring good governance practices to generate investment returns," said Solomon.

"At the end of the day, the first order is ‘make money, make a difference.' But making money has to come first. Our goal is to beat the benchmark and the peer group," added Solomon. He noted that Hermes produced a recent study that shows firms with strong corporate oversight have outperformed poorly governed competitors by an average of 30 basis points a month since 2009. "We want to make changes that affect the way companies look at ESG factors and so they will integrate them to get better performance. It just makes sense."

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