ESG integration on rise, but issues remain

Integration of environmental, social and governance factors is moving toward the mainstream of institutional investment management.

But users lack agreement on factors, weightings, scoring, standards and definitions, as well as application into investment analysis.

A combined 1,380 investment managers, asset owners and other investment-related organizations worldwide representing $59 trillion in assets had signed the United Nations-supported Principles of Responsible Investment as of April 2015, according to PRI's latest numbers. Those figures are up 9.5% and 31.1%, respectively, from April 2014.

Signatories agree to implement a voluntary set of six principles incorporating environmental, social and governance factors into investment decision-making and ownership practices.

In its latest biennial report released last year, the Global Sustainable Investment Alliance — a coalition made up of the US SIF Forum for Sustainable and Responsible Investment and other responsible investment associations worldwide — showed assets under management incorporating sustainability investment strategies reached $21.1 trillion globally at the beginning of 2014, up 61% from the beginning of 2012.

“The mainstream is just getting their heads around” ESG, said Ben Yeoh, London-based senior portfolio managers, global equities, RBC Global Asset Management.

Noted Alex Bernhardt, Seattle-based principal, U.S. responsible investment leader, Mercer LLC: “If it's not mainstream now, it's trending that way for sure. Everyone knows what the acronym stands for now. That's progress. In that sense, yes, we are mainstream.”

But “to the extent that ESG factors are integrated into every investment process or investor decision, we are far from that point.

“All the indicators we track are pointing toward more sustainable or responsible investing and not less,” Mr. Bernhardt added. “I don't see this leveling out anytime soon.”

Heather H. Myers, New York-based managing director, non-profits, Russell Investments, was a bit more cautious. “I wouldn't say it's mainstream yet,” she said. “But it's certainly being talked about a lot more than it was a couple of years ago. ... A lot of asset owners, if they haven't moved there (to ESG) yet, what they really want to figure out is how does (ESG) work for them.”

Large institutional investment managers increasingly are moving to ESG integration. Managers reported fully integrated ESG AUM at $4.8 trillion as of the end of 2014, up from $1.4 trillion at the end of 2012, according to a report covering 16 money managers released in October from US SIF Foundation.

The report defined integration as a systematic, explicit inclusion of ESG into traditional financial analysis.

“The next stage for money managers ... is to provide more disclosure around practices, specifically ESG criteria they consider and how they systematically apply integration” to allow institutional investors to better evaluate the use, Meg Voorhes, US SIF director of research and co-author of the US SIF report, said at the time the report was released.

Elsewhere, ESG integration is further advanced.

“Looking at Europe, a majority of fund mangers incorporate ESG,” said Ulrika Hasselgren, Stockholm-based managing director and head of sustainable and responsible investment, Institutional Shareholder Services Inc.

Drivers of ESG use come from asset owners, government regulation and stock exchange listing rules.

Some 29% of U.S.-based asset owners incorporate ESG risk factors into their investment decision-making, according to results of a Callan Associates Inc. survey released in November of 240 asset owners representing a combined $2.4 trillion in assets. That's up from 22% in 2013, the only other time Callan has done the survey.

“Clearly this (kind of pressure) is what we see all around Europe and to a growing extent in the U.S.,” said Ms. Hasselgren. “That of course pushes the fund mangers to integrate these issues and implement strategies that provide solutions.”

A CFA Institute survey of members, released in August, found 63% of respondents take ESG issues into consideration to help manage risk. Some 44% of respondents did so because of client demand.

“We are having so many more conversations with clients about these issues. It has really come up on their radar screens, whether it is in the U.S. or in Europe,” said Jessica Ground, global head of stewardship, Schroder Investment Management Ltd., London. “They are lot more interested. That has to do with millennials being more interested in this.”

In governmental action, Mr. Yeoh said the change to ERISA regulation — specifically a Department of Labor interpretation in October greenlighting fiduciary consideration of sustainability factors into investment decision-making — “is also adding momentum” toward ESG integration by money managers.

“That (DOL interpretation) makes people more comfortable to consider it,” said Ms. Myers of Russell Investments.

The European Commission is developing non-binding guidelines, set for completion in December, for companies to disclose non-financial information, including efforts to boost director and management diversity.

And earlier this year, Ontario put into effect legislation requiring pension plans to disclose whether they incorporate ESG factors and if so, how.

“Other pools of capital in Canada are saying, well, maybe that is going to impact us sooner and let me start thinking about ESG,” said Ms. Myers.

The Financial Stability Board is further pushing institutional investors toward ESG, said Mr. Bernhardt. In December the FSB — made up of financial system regulators worldwide — created a task force to develop a voluntary standard on climate-related financial disclosures for use by companies to provide such information to investors and other stakeholders.

The World Federation of Exchanges in November called on securities exchanges to embrace a set of 34 environmental, social and governance factors into their disclosure guidance for companies listed in their markets to provide a uniform corporate reporting framework for investors.

Such disclosures would benefit listed companies by enhancing their ability to attract long-term institutional investors, according to a statement from the WFE, which represents 64 public stock, futures and options exchanges.

“But public disclosure won't always tell you the whole story,“ Schroder's Ms. Ground said. “It's a starting point for asking more questions.”

Academic research is another driver of ESG use. “We expect a continued uptick in ESG integration by asset owners and managers,” Doug Morrow, Toronto-based associate director of thematic research at Sustainalytics BV, said in an e-mail. “This is being driven by growing evidence about ESG's risk/return enhancements as well as more disclosure by companies about their ESG performance.”

Ms. Ground pointed to academic studies showing benefits to lowering corporate cost of capital and improved investment performance.

Richard Grottheim, CEO of the $32 billionAP7, Stockholm, takes a more balanced view. “Twice we have had a Swedish academic (go) through all the academic research on whether ESG improves or detracts from performance, and she has found twice now it goes both ways. Some studies show it's positive for returns and some others that it is negative. But most of them actually find that it is neutral.”

The growing ESG marketplace is driving acquisitions and partnerships.

Glass Lewis & Co. and Sustainalytics in February introduced a partnership the two firms formed to integrate Sustainalytics' ESG research and ratings on more than 10,000 companies into Glass Lewis' proxy research and voting management platform.

ISS acquired Ethix SRI Advisors in September to rebuild its environmental and social capability after MSCI Inc. sold ISS. “We had to rebuild that business,” said Stephen Harvey, New York-based ISS chief operating officer. Also that same month, Sustainalytics acquired ESG Analytics, whose analysis software helps money managers and asset owners analyze and manage ESG risk and opportunities

And in July, Goldman Sachs Group Inc. bought Imprint Capital Advisors LLC, which applies socially responsible investing.

For all the buzz, money managers still are grappling with how to integrate ESG.

“This has been done in different ways, using different strategies, different investment philosophies,” Ms. Hasselgren said.

“Depending on who you ask, you will get different answers because it (ESG incorporation) is an interpretation that will be subjective at each and every fund manager.”

With ESG data, “there is not one standard of what ESG means,” presenting a challenge to institutional investors, said Ms. Hasselgren, who suggests companies in each sector “work out what are the relevant metrics ... to disclose on in relation to an ESG framework.”

“In North America there is an ... issue between what people are calling (socially responsible investment) and what people are calling ESG,” Mr. Yeoh said. “Actually they are very different. SRI ... which has come very much from the mission-based investment around exclusion is a very different form of thinking. ... (ESG) is not exclusion-based, but is very much more based on assessing non-financial factors for both the risk and opportunities, which might be material for an investment case.”

Yves Choueifaty, CEO and founder of TOBAM SAS, a Paris-based institutional investment management firm, said ESG “is not about doing things that are moral or immoral ... what is good and what is evil. It's really about whether steps corporations are taking are compatible with sustainability” for long-term performance.

Looking forward, TOBAM intends to direct most of its ESG focus on corporate governance, Mr. Choueifaty said. “If we want (companies) to be effective in terms of social behavior and environmental behavior, the best way to do that is to make sure first of all that the board is diverse and is really empowered vs. the executives of the company.”

How a money management firm integrates ESG can reveal the strength of its input into the investment process, said Ms. Ground of Schroders.

It's “important that the actual integration happens by the financial analysts themselves,” Ms. Ground said. “We very much have ESG (analysts) and financial analysts working together,” but the final decision belongs to the financial analysts, who are doing fundamental investment work.

At RBC, “it is the portfolio managers (who) are doing this assessment ... embedding it into their investment process,” Mr. Yeoh said. “We don't have a separate suite of ESG analysts.”

Without portfolio managers making the ESG investment decisions, money management firms “are not truly integrated because they aren't making the decisions against what is a material risk or opportunity,” Mr. Yeoh said.

Investment consulting firms have been helping drive ESG integration.

Mercer has been scoring investment managers and strategies since 2005. In 2012, MSCI began offering portfolio analytics services, enabling asset owners and managers to analyze their ESG risk exposure as well as comparisons with ESG-enhanced and standard benchmarks.

In March, MSCI introduced ESG scoring of mutual funds and exchange-traded funds, using its own ESG metrics. Morningstar Inc. also in March unveiled its sustainability ratings to score how mutual funds meet environmental, social and governance challenges. Morningstar is basing its ratings on Sustainalytics ESG ratings on companies.

“The market doesn't look at ESG in one way,” said Linda-Eling Lee, global head of ESG research, MSCI, New York. MSCI makes available fund ESG metrics so clients can conduct an evaluation with regard to their views on what ESG might mean, Ms. Lee said.

With managers accounting for more than 50% of assets under management worldwide embracing U.N. PRI, “as far as that initiative is concerned we have reached critical mass,” Mercer's Mr. Bernhardt said. “However, not every signatory of the U.N. PRI is fully compliant or at the same stage of development of their ESG integration process.” That's where ratings “can help distinguish between leaders and laggers.”

The number of top-scoring investment portfolio strategies in Mercer's universe of 5,500 that it tracks has changed little over the last few years, Mr. Bernhardt said.

Some 12% of strategies scored in ESG 1 and ESG 2, Mercer's top ratings, as of March, compared with 10% in June 2014, Mr. Bernhardt said in a follow-up e-mail.

“While (ESG) awareness is increasing, the quality of approaches isn't necessary increasing a pace,” Mr. Bernhardt said. “There has been some progressive but it has been relatively slow.”

Money managers also face challenges in quality of data underpinning ESG, which has financial consequences.

“ESG data from companies are steadily improving,” in part because of the interest in the company to do so, said Ms. Hasselgren. “If data (are) poor and wrong investment decisions are made, that will harm not only the investor but the company.”

TOBAM's Mr. Choueifaty said: “Corporate governance data is much more reliable than the data gathered on the other dimensions of ESG. The corporate governance data are very objective. They are very factual. The other data (E and S) ... is really based on opinions rather than facts.”

Most of environmental and social problems can “be dealt with (through) good corporate governance,” Mr. Choueifaty said.

For that reason, TOBAM will turn its ESG focus more toward corporate governance.

“We are still in the research step” in developing the program and could start the corporate governance initiative toward the end of the year, Mr. Choueifaty said.