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Finding the Signal in the Noise

By December 14, 2017No Comments

The practice of integrating ESG factors into investment decisions is growing, but are asset managers and owners making the right decisions about which factors to focus on? The answer is, not often enough, despite research by George Serafeim and others at Harvard Business School which concluded that company financial performance is only improved if a given ESG factor or issue is relevant, or material, to that company in its industry peer group.

As a growing number of asset owners and asset managers are interested in integrating material ESG factors into their investment decisions. Those not yet involved in the practice are asking both what ESG integration means and why it makes sense to do it. In October, the High Meadows Institute brought together a number of investment professionals to discuss those questions.

One of our industry experts said that her firm defines materiality by focusing on ESG themes that will drive the return profile of a given security or that could impact the volatility or risk profile of that security. Her firm looks at ESG integration as a way of improving portfolio performance, not in an effort to screen out companies that aren’t embracing ESG. Another asset manager, working in fixed income, finds SASB’s definition of materiality a valuable resource as her firm seeks to identify extra-financial factors that are important for their long-term investment horizon.

When determining what weight to give ESG factors in their investment process, another expert added that her organization identifies what’s material to the portfolio while taking liquidity needs and risk factors into consideration. A pension fund has different liquidity needs than an endowment and must manage risk to ensure payment for beneficiaries, and different ESG issues impact liquidity and other risk differently.

However, making these determinations requires data, and, unfortunately, there’s a data problem in ESG integration. There is a lack of standardization on how companies report ESG data and the data that is disclosed is self-reported. Additionally, there are numerous definitions of materiality and frameworks (including SASB and GRI), making these efforts even more challenging. Disclosure by businesses, already a resource intensive process, is made difficult by the fact that the industry hasn’t coalesced around a common ESG materiality and reporting framework.

To identify ESG issues that matter, one firm with a fundamental approach begins by generating a fundamental thesis about a specific ESG factor. They also develop a behavioral economics rationale to ascertain why that particular ESG information isn’t yet arbitraged by the market. Once the signal is selected, the firm formulates it in a way that makes sense given their economic intuition and then conducts a battery of tests to find out if the signal adds value to the portfolio, particularly after accounting for standard signals value. They are looking for robust efficacy before accepting that the ESG factor is adding value.

At many firms, the demand for material ESG integration comes from a confluence of internal interest and client demand. One expert’s firm combines their strong internal conviction to strengthen the investment research process through consideration of ESG factors with a growing interest from clients, whose thoughts and ideas help the firm innovate and explore different avenues, to drive their ESG integration practices.

Interest in material ESG integration is likely to grow, making the move to a focus on materiality easier. In the near future, our panel thinks there will be more disclosure and increased standardization for ESG data; better ways of filtering data; growth in ESG-themed products and investment opportunities; and an increase in impact investment.