As institutional investors increasingly demand that money managers integrate environmental, social and governance factors into portfolios, third-party ratings used to inform decisions are under development, evaluation and in some cases reconstruction.
Money managers have at their fingertips analysis, data and overall ESG scores to help them evaluate thousands of companies. These scores come from a variety of providers, from broader coverage across the entire spectrum to more specific evaluations, such as those focusing purely on climate change.
These scores are used not only by active money managers to help with investment decisions but also in the creation of exchange-traded funds and other index-tracking strategies.
Now, the proliferation of ESG strategies is bringing more attention to these ratings. Assets invested in global ESG ETFs and exchange-traded products increased 6.8% to $22 billion in August, show data by ETFGI LLP, London.
A number of money manager sources say that much ESG data is backward-looking and is skewed in some cases toward certain regions. Therefore, they're choosing to work in different ways to incorporate and enhance these ratings.
These limitations are acknowledged by the providers themselves. Sustainalytics has for the past three years been working on new methodology, addressing some of the core areas that clients repeatedly bring up and working to capture new information, said Diederik Timmer, head of client relations at Sustainalytics in New York.
Also, for the past year or so, the firm has been working harder to keep its data fresh. "For us, it is really important the information we have on company management is accurate and up to date," something particularly important for smaller companies that may not update that frequently.
"And as part of that, we also send our research to companies and ask for feedback — that gives the company an opportunity to give us information that we couldn't find, and also is a quality check," he added.
Other providers also recognize the need to keep developing. MSCI Inc. is in contact with both active and passive managers, said Guido Giese, executive director, applied equity research at MSCI in Zurich. "There are close to 80 ETFs tracking MSCI ESG indexes, and increasingly active managers are integrating ESG ratings into their strategy as they understand its use as a proxy for how well companies are managed. Poor ESG ratings are viewed as a reason to be cautious, as they incorporate this additional information into the stock selection process," he said.
And for ESG and sustainable finance to truly scale up, "we need to address some of these concerns head on," said Lauren Smart, London-based managing director, global head of financial institutions business at Trucost Ltd., an arm of S&P Global Inc. "Some of that is to do with the ratings and data, and some education around what the data is and isn't telling you, and how ESG funds are constructed," she said.
Ms. Smart said the challenge is that a lot of data — maybe 100 data points covering different variables — are wrapped up in a single ESG rating. "But sometimes what could be considered most financially material could get lost in the noise."
Trucost executives have identified a number of emerging investor requests, such as the need to create data in the absence of disclosure in private markets and coverage beyond listed equities.