The tone surrounding ESG-related investing looks set to change as President Donald Trump issues executive orders to lighten business regulations and introduce less-onerous environmental standards.
In adapting to this new paradigm, the debate about the importance of environmental, social and governance factors to the investment process is sure to resurface. On the cusp of the mainstream, the question is whether ESG will continue to be as relevant in this changed political environment.
Beyond fad or fashion, a cornerstone of the argument for ESG's continuing importance is its ability to generate alpha. In spite of a growing body of academic research suggesting ESG factors are a source of business outperformance, many investors are yet to be convinced. A recent study by RBC Global Asset Management found less than a third of the professional investors surveyed believe ESG is a source of alpha.
This view might be partly the result of legacy expectations associated with strategies that screened against specific ethical or values-based objectives. Such negative screening has been criticized for limiting the universe of investment choices.
An alternative approach to ESG investing is to look beyond regular company reporting.
By placing more emphasis on non-traditional information sources relating to factors such as employee or supplier engagement, effectiveness of research and development, or staff training, the investor can build a richer, forward-looking picture of a business's activities, processes and culture. Much of what falls under these categories does not appear in backward-looking financial reporting but relates to the company's quality of management and future strategy.
One challenge is the attempt to measure ESG factors in the same way that an investor measures a company's financial performance. This approach is often impractical because of the differing nature of the information, much of which is qualitative rather than quantitative. Whereas financial reports adhere to globally accepted accounting guidelines, a company's grasp of its environmental and social impact might be at best an approximation. For example, company culture and human capital are important parts of the long-term sustainable value of a company. However, it is not adequate to boil this down to a 7/10 rating or “BB” grade and suggest that rating provides a meaningful indicator or analysis. Similarly, although companies are increasingly adopting “pulse-check” surveys of employee opinion as best practice, these are both subjective and unique to each company.
Another way to approach ESG is as a way of identifying non-traditional sources of risk. The core principle here is that companies must keep their activities in balance with the needs of all external and internal stakeholders over time. Overborrowing from any constituency will create “contingent liabilities” — liabilities that do not appear on the balance sheet — which must eventually be paid back. Conversely, good practice such as investment in the company brand or R&D will create contingent assets and possible sources of competitive advantage.
For example, failure to invest in adequate staff training, will eventually feed into poor employee engagement scores and weaker customer satisfaction. It could also become a factor in industrial accidents. Similarly, we have all seen how failure to foster and enforce an ethical business culture can affect the share price of even the largest blue-chip global companies.
While this might seem intuitive or logical, it is noteworthy that our ESG study found 40% of money managers still do not think of ESG as a risk mitigator. This reflects the wide differences of opinion that exist about ESG's importance and how best to incorporate it into the investment process. (RBC Global Asset Management conducted an online survey around responsible investing in 2016. The survey was distributed to 1,000 institutional asset owners, wealth managers and pension plan consultants. Ninety individuals completed the online survey.)
Integrating ESG into our fundamental research practices has proved successful in identifying alternative sources of alpha. Arguably, the outperformance derived from non-traditional information sources is idiosyncratic in nature and has a low correlation with more systematic, quantitative approaches. Integrating ESG is particularly effective when combined with an active approach to share ownership, allowing more informed judgments to be made about a company following close engagement with its management team and/or directors.
ESG-related risks will certainly continue to exist within companies regardless of developments in the political arena. Understanding those risks will continue to provide additional insight into potential areas of alpha and/or underperformance.