If you want to bake a cake or fix a plumbing problem, you can easily find a recipe or instruction manual to tell you what to do, step-by-step. When it comes to investment strategies based on environmental, social and governance (ESG) criteria, there is no recipe that tells investors and corporations, “add ¼ cup of this and two tablespoons of that” to obtain the desired outcome.
The industry has come a long way since its earliest days, but in many respects we are still in the early days of ESG. The terminology, data, regulations, voluntary standards, and investment strategies keep evolving. If you have been reading even a bit about sustainable investing, you probably realize that whatever you read is just the (cliché alert) tip of the iceberg. Even those of us who are immersed in the ESG world know that the landscape is evolving as investors, asset managers, regulators, corporations, and citizens of Planet Earth learn more about sustainability.
Here, we ambitiously attempt to summarize one key aspect of the ESG investment landscape, namely the approaches asset managers commonly use to create their ESG offerings. We say “ambitious” because our goal is to briefly summarize a topic that we could discuss for hours, but we hope this whets your appetite to learn more.
The four basic approaches summarized here are:
- Screening/Exclusion
- Best-in-Class
- Best-in-Progress
- Integration
Screening/Exclusion
This is the oldest approach, and perhaps the easiest to define (although the devil is definitely in the details). Using “negative screening”, an investment manager creates a portfolio by starting with a universe of securities (such as the S&P 500, the MSCI Europe index, etc.) then screening out entire industries and/or companies that are engaged in certain activities. This could be almost anything—alcohol and/or tobacco companies, casinos, nuclear energy, and so on. Screening can also target companies that are in violation of certain standards, such as the Kyoto Protocol or the UN Global Compact. There are also positive screens, which limit a portfolio to companies that are involved in specific areas such as renewable energy, electric vehicles, carbon capture technologies, and so on. There is much more to say, but we promised to be brief. For more details, see this document from the Principles for Responsible Investing.
Best-in-Class
The best-in-class approach chooses companies that are leaders in their industries based on selected ESG criteria. “Well…” you might be thinking, “that sounds good. Why wouldn’t I want to invest in the best?” And this could be the right approach for you, particularly if you do not want to exclude entire groups of companies from your portfolio. This approach selects companies from all sectors, so it provides better diversification and overall market exposure than screening/exclusion. One big question is, how is “best” defined? Typically, an asset manager relies on scores or rankings from an ESG ratings provider, and it has been well documented that these scores vary dramatically from one source to another. OWL ESG’s Consensus Scores were specifically created to address this problem, but don’t just take our word for it. This three-part article from GreenBiz (which definitely does not attempt to be concise, as is our goal here), does a fairly deep dive into this issue.
Best-in-Progress
This approach, which is somewhat newer than the previous two, invests in companies that have improved their ESG performance the most with respect to the chosen criteria over a specific period (the “how is ‘best’ defined?” question applies here, too). One argument in favor of this strategy is that best-in-progress companies can offer more of what may be thought of as “ESG alpha” – i.e., excess returns attributable to ESG factors – because they have not been “over-bought” by best-in-class investors but are upping their game in terms of ESG. That could attract more investor attention, increase market share, improve profitability, and create value.
Some argue that it is not “fair” to reward companies that show a big improvement from a weak starting point—ESG leaders are unlikely to show significant progress because they are already in front of the pack. It’s like comparing a child who raises the score on a math quiz from 60 to 80 to a student whose score increased from 90 to 95. The first child (best-in-progress) improved by a whopping 33% while the “best-in-class” child had “only” a 5% gain. Kudos to both, in our view, but for different reasons (big disclaimer: ESG investing is not like grading math quizzes).
ESG Integration
In this approach, an active manager integrates ESG concepts into its process for choosing stocks. Each company’s exposures to ESG risks and opportunities are evaluated along with financial strength, management quality, and other criteria. This approach requires research and asset managers may include engaging directly with company management to dig into these issues. Therefore, this cannot be a passive or automated approach that relies on ESG scores. Of course, a manager may decide to discount or even completely ignore whatever it learns about a company’s vulnerabilities with respect to ESG, but it does so knowingly.
The integration approach has become increasingly popular, but greenwashing has reared its ugly head here. Recently, BNY Mellon Investment Adviser agreed to pay a $1.5 million fine to the Securities and Exchange Commission for “misstatements and omissions” regarding certain ESG mutual funds it manages. The prospectus for the funds claimed that every position held had undergone an ESG review, but in levying the fine, Sanjay Wadhwa, deputy director of the SEC’s Division of Enforcement and head of its Climate and ESG Task Force, said “…our order finds that BNY Mellon Investment Adviser did not always perform the ESG quality review that it disclosed using as part of its investment selection process for certain mutual funds it advised.”
All of these approaches, and others that will probably be developed in the future, require robust ESG data, and the ability to use that data to make informed decisions about how to invest in a way that helps to make the world a better place. That’s what OWL ESG is all about.
