Investors have more choices than ever, and portfolio managers are evolving their approaches to meet demand. Here we look at what goes into an ESG-focused portfolio.
Responsible investing (RI) funds have always attempted to balance financial gain for investors with strategies that support positive change in the world. At one time this equation seemed straightforward: many portfolios simply avoided “bad” areas of the market, such as tobacco or weapons, by implementing blanket exclusion rules on those types of investments.
But as awareness of the benefits of responsible investing has swelled among investors in recent years, the range of investment approaches and choices has also expanded. RI fund managers are applying increasingly sophisticated environmental, social and governance (ESG) analysis to a wider range of potential investments, and this information is often incorporated into the investment process alongside traditional financial analysis and metrics. While some funds provide just enough oversight to “tick the ESG box,” others invest considerable resources to support positive, measurable change through active ownership activities.
Given the wide range of approaches available in this rapidly evolving segment, it’s important for investors to understand some of the key RI building blocks. Here’s a look at some of the more common approaches.
The baseline: screening tools
One of the most useful and popular resources available to investment managers in evaluating ESG factors are filtering programs known as “screens.” While some portfolio managers develop their own proprietary evaluation tools, many rely on screens developed by third-party index providers and specialty ratings firms to select or discard investment options. These screens are typically applied early in the investment process based on the ESG priorities of the mandate.
Screens use artificial intelligence and sophisticated data modelling to assign a “score” to potential investments, measuring how they are performing in relation to their ESG responsibilities and similar securities. Scores can vary substantially based on the methodology and approach of the provider, and ratings are updated constantly as the investment environment and relevant data changes.
Screening approaches tend to fall within three main categories:
Positive screens help managers to select companies that demonstrate positive or improving ESG performance compared to their peers, such as those with strong environmental protection policies, progressive employee relations, board and workforce diversity, and responsible executive pay practices. Some screens will endorse best-in-class or industry “leaders,” or highlight positive thematic developments such as companies in energy transition, renewable/clean technology, or progressive social enterprises.
Negative screens, often used in conjunction with positive screens, are designed to avoid the worst-performing issuers, regions or entire sectors that the investment manager perceives as having poor ESG practices, or companies that have a negative impact on society through the products or services they provide.
Norms-based screens evaluate companies against accepted guidelines, regulations or international frameworks, such as OECD guidelines, United Nations treaties or other widely accepted international agreements.
Digging deeper: due diligence and asset allocation
While screens provide a valuable starting point for many responsible investment mandates, how this data is incorporated into the overall investment decision-making process is a key differentiator between basic ESG funds and leaders in the RI space.
To clearly evaluate the ESG risks and opportunities of a particular investment, many RI managers go beyond the use of screens by adding layers of analytic rigour to the investment process. ESG integration techniques, for example, explicitly embed ESG considerations into the traditional financial analysis of a security to help portfolio managers:
- gain a complete picture of each investment’s ESG profile and the potential for improvement
- control risks by applying additional scrutiny in order to rule out false claims or misinformation, known as “greenwashing”
- make strategic and tactical allocation decisions to emphasize or limit asset classes, regions, sectors, currency, style factors, duration, credit ratings or currency based on the goals of their mandate
- invest in corporate leaders set to benefit from specific positive ESG “themes” such as climate change or diversity
Many portfolio managers perform their own research to implement these strategies, asking companies and issuers to complete ESG questionnaires to help strengthen their investment decision making and assess and manage their collective ESG risk exposures, while others access an increasing body of third-party research and analysis.
This approach is also supported by emerging securities regulations asking for consistent, complete ESG disclosures on behalf of fund managers. The European Union has taken the lead with its Sustainable Finance Disclosure Regulation (“SFDR”) requiring asset managers and financial advisers to make ESG information available to potential and current investors. The Canadian Securities Administrators has also proposed mandatory climate-related disclosure requirements for public companies, and the U.S. Securities and Exchange Commission is considering a mandate for public companies to release consistent climate-related risk information.
Making change: active ownership activities
Once an investment decision has been made, many responsible investment asset managers continue their work to understand the potential ESG risks and opportunities of the companies in their portfolios, but more importantly to actively engage with those companies to extend their influence beyond simple investment or divestment decisions.
Impact funds, for example, often employ resource-intensive advocacy activities to encourage measurable change that can support financial returns. These activities, which require additional investments in data, expertise and measurement, can include:
- opening dialogue with management teams and corporate boards to encourage concrete action on ESG factors
- collaborating with like-minded investors and regulatory bodies to perform advocacy work
- proxy voting to influence companies to enhance disclosure on certain issues, change policies based on evolving ethical standards
What does it all mean for investors?
Clearly, translating investor desires to have a positive effect on the world through their investments can take many forms, and not all responsible investing strategies are created equal. To really know what they are getting and the positive impact their investments are creating, investors should seek the following information from their fund company:
- What is the manager’s responsible investment philosophy?
- How exactly does the manager implement that philosophy as part of the investment process?
- What RI-related activities, such as corporate engagement, proxy voting and policy work does the manager engage in?
A reputable responsible investment manager will have all this information easily accessible to investors.
By seeking more information about how their ESG portfolios are managed, and the extent to which asset managers are driving change, investors can discern among the range of options available and make an informed decision.