Three reasons why ESG factors matter to alpha-driven investors

Key points

• It increasingly makes sense to include ESG factors in investment decisions and risk assessments, as the current bout of extreme heatwaves sweeping much of the northern hemisphere demonstrates
• Indeed, an asset manager failing to incorporate these factors when calculating long-term investment value, would be failing in their fiduciary duty
• At a time of slowing global growth and upheavals in societal norms, ESG factors could help to guide investors through potential financial market storms and volatility that lie ahead
• Ultimately, the real question shouldn’t be whether an investment manager incorporates ESG considerations into portfolio decisions, but how well they do so

Avoiding environmental, social, and governance factors when making investment decisions can be costly. Their use in asset management is becoming standard practice. As global growth splutters and long-term megatrends reshape society, can environmental, social, and governance (ESG) help guide investors in the right direction?

Recent criticisms of environmental, social, and governance may make some, less familiar, investors question its role and value.

But don’t be fooled by these distractions. Investing using such considerations is becoming conventional.

Investment managers use an ESG lens to assess a company’s operating practices

ESG data provides information about how a company operates on non-financial metrics.

Organised into three general categories, ESG metrics span numerous topics, such as carbon emissions, labour practices, and corporate governance structures. These metrics apply to any, and every, business. However, their financial relevance or materiality varies by industry and time.

Investment managers are using the data to assess and make comparisons of these internal operating practices to gain insight into how well an organisation is run. In actual usage, it’s primarily a risk mitigation tool.

As such, it should be clear what it isn’t. Incorporating ESG considerations is:

• Not about being moralistic
• Not about excluding a particular sector (such as fossil fuels)
• Not about thematic investing
• Not going to “save” our world
• Not an umbrella term for all forms of sustainable investing
• Not carried out identically by all investment managers

Instead, it’s an innovative, and still evolving, improvement to current investing doctrine. Below are three reasons investors should expect its use by their investment managers – with the aim to improve investment outcomes.

1. Managers should use every available data point, including ESG data, to improve their investment decisions

Effective investment decision-making requires making a judgement using available data and information. Prior to the arrival of ESG data, investment managers relied only on financial data. They may have had views about topics such as governance, or culture. But there was minimal data to inform or support their views.

Now managers have this data, even if not perfect, to improve their analysis. Moreover, it’s sensible for them to assess the risks for a company of, say, climate change in relation to its potential physical effects from extreme weather, preparedness for regulatory changes, or changes in customer preferences.

These are material issues where a changing world has an impact on a company’s profits and losses¹.

Any rational investor would want their manager to have, and to use, this additional data to inform their decisions. The alternative? Ignoring it, would disadvantage them in terms of information asymmetry.

2. Managers’ fiduciary duty requires inclusion of such factors

As a fiduciary, investment managers are required to act for the benefit of their clients. More specifically, their fiduciary role expects:

A duty of prudence, to operate with due care, skill and diligence

A duty of loyalty, to act solely in the interest of beneficiaries, operating impartially and avoiding conflicts of interest

In 2005, the law firm Freshfields Bruckhaus Deringer was asked to determine the relationship between ESG and fiduciary duty. Their report², A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, concluded that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” [emphasis added]

Since that time, this practice has become widespread, growing empirical and academic evidence is highlighting when and how ESG factors are financially material, and regulatory frameworks around the world have enshrined, and driven further, consideration of them.

At this point, a manager failing to include ESG factors to assess long-term investment value would be failing in their fiduciary duty.

3. ESG factors, as a framework, should inform managers’ broader view of the markets

Investment managers face, simultaneously, the current period of a deteriorating macroeconomic backdrop while megatrends are driving deeper societal changes. Economic signals and indicators are divergent both in direction and by location.

Managers are looking at significantly different circumstances than they have seen in decades. Markets are reacting with uncertainty and volatility. Here, ESG factors can provide a framework to make sense of wider market conditions and deeper questions being raised. For example:

• How do we solve simultaneous issues of energy security, affordability, environment, and just transition?
• What will be the implications of demographic shifts of the oldest generations living longer, and the younger “Gen Z” one expected to become more than a quarter of the workforce by 2025³?
• How will companies be regulated and taxed to account for their role and contribution in society?

As noted before, investing in this manner does not seek to solve the above issues directly. It can decarbonise an investor’s portfolio from climate risks, but does not decarbonise the planet. Nonetheless, ESG factors and data can provide greater visibility into wider trends as well as how historically-accepted externalities will be dealt with by companies, citizens, and governments.

Investors are expecting managers to navigate their portfolios through the rough times ahead. ESG factors can’t steer the boat. But they serve as tell tales and horizon scans of conditions for savvy managers.

Generating financial value from ESG factors rests on skill, not simply having the data

The above reasons should remind investors why they should want their managers to use ESG analysis on their behalf. That said, using such considerations doesn’t automatically guarantee outperformance for an investment manager.

Consider giving the same violin to a six-year-old and a Royal Philharmonic’s first chair. You don’t blame the instrument for the quality of the music produced. Exceptional performance in this case, as well as in investing, is driven by the talent and skill in using their instruments.

In the end, the real question for investors shouldn’t be 'Does the investment manager incorporate ESG considerations?', but 'How, and how well, do they?'

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