ESG investing: Why we believe an active approach is optimal
The ‘active versus passive’ investing debate is well documented and has rumbled on for years. However, when it comes to investing from an environmental, social and governance (ESG) perspective, we firmly believe active investing is the optimal route.
Active investment management is fundamentally about aiming to deliver a better outcome than that provided by simply investing in a strategy tracking a market index. When active management succeeds it can deliver index-beating returns with hopefully lower volatility.
To generate that outcome, active managers create diversified portfolios by investing in securities based on fundamental or factor analysis rather than by sizing allocations based on the individual weights of securities in a benchmark index. The allocation decisions can be driven by macro, valuation, style and thematic factors.
In contrast, passive strategies give no consideration to a company’s individual fundamentals or their relative value, and if the market falls, so do they.
ESG considerations introduce additional dimensions to the active process in terms of identifying both opportunities and risks. A focus on these factors allows active managers to identify and quantify potential ESG risks coming from a company’s operating model and make judgements about the materiality of these risks.
Such analysis could look at how a business’s operations impact the physical environment, or how a firm is exposed to climate risk – and how in turn this could put a company at risk from regulatory decisions, taxes, disruptions to supply chains, adverse shifts in consumer preferences or more. For example, how would a firm be affected by disruptive weather events? What impact would it have on its operations, supply chains and workforce? Understanding such risks plays a vital role in valuing a company.
Social factors include human capital management and interactions with various stakeholder groups – labour in the supply chain, local communities, as well as customers. Governance is clearly important in that a lack of robust oversight can lead to issues around taxes, excessive executive pay and even illegal activities.
Clients are increasingly demanding that their asset managers target non-financial outcomes in their investment strategies, as they combine responsible investing considerations with their objectives for returns.
It is essential to assess how ESG factors could affect a business and its potential future profitability. Active managers can pursue ESG analysis to identify, quantify and judge the materiality of the risks a company may be running, through an ESG lens. The bottom line is that it is better to be aware of these risks, and to take the necessary portfolio action, should they materialise before they have a detrimental impact on a company’s financial performance.
At the same time, firms with better ESG profiles are potentially more likely to perform better over time. For example, traditional fossil fuel producers need to, and are, adapting their businesses as they know that if they do not, they won’t have a future and will be left with stranded assets.
In areas such as climate change, ESG analysis allows active investors to identify the laggards and the climate leaders – those companies which already have a low carbon dioxide output. It also highlights the transition leaders i.e. those that are on a certified path to lower emissions in line with the Paris Agreement of limiting global warming to well below 2°C - but preferably to 1.5°C - compared to pre-industrial levels. Increasingly, capital will flow to the better performers from an ESG point of view which in turn will put those companies at a financial advantage and in a potentially better position to deliver higher returns to shareholders and a better credit profile to bond holders.
Allocations can favour the leaders and the enablers of technology related to climate change and exclude those falling behind the curve. I believe a passive approach would result in a sub-optimal allocation across these types of companies.
As ESG investing has become central to many investment processes, there are additional inputs into security analysis that allow active managers to also target non-financial factors in the investment outcome. Databases of ESG factors are used to create ESG profiles at the individual security level.
The ESG analysis complements fundamental financial or security behaviour analysis to enhance the stock selection process. Active managers can therefore choose securities based on their fundamentals – earnings growth, profitability, cash-flow generation and so on – as well as their ESG profiles.
Some of the ESG tools available to active managers are shared with the passive investment approach. However, active managers have a broader set of tools to influence the behaviour of companies in terms of their ESG profile. Not least of these is the ability to adjust allocations dynamically through time to optimise both financial and ESG outcomes - active managers, in contrast to passive strategies - can after all take advantage of price volatility.
Active managers rely on the growing availability of data in the ESG field. Increased disclosure and more transparent reporting on all aspects of ESG are proving to be crucial in determining whether, and how much, to invest in a particular issuer.
Regulatory developments such as the Task Force on Climate-related Financial Disclosures (TCFD) has put greater pressure on companies to disclose in detail how their operations are affecting the environment which in turn have helped broaden and deepen databases. Simultaneously, active managers have been developing tools to help model the data, especially regarding some of the more complex ESG areas like decarbonisation.
Using ESG data supports active stock selection based on approaches like best in class, concentration and active risk measured by things like active share in equity portfolios and tracking error. These techniques lead to different weightings and risk profiles to a passive portfolio. Increasingly, sustainable funds target a better overall ESG profile for their portfolios than that of a reference index. More and more also align the portfolio and performance metrics with specific sustainability targets typically as described by one of the United Nations Sustainable Development Goals.
Other tools available to active managers include voting and engagement. Active managers can use their positions as owners and creditors to influence company management through regular engagement on ESG as well as business matters. Votes against company management are an effective tool – especially when like-minded active managements come together – and investors can propose resolutions at annual shareholder meetings to address ESG issues.
Of course, passive investors can do this as well and play an important role in influencing management. But active managers can underweight stocks if they feel management is not meeting expectations on ESG issues – and that can be beneficial to the overall ESG profile of the portfolio.
There is often a focus on active managers also having the ultimate tool of disinvestment (or total exclusion). In my view this should be used as a last resort and only when engagement with the company has failed to result in significant change. Of course, individual investors and asset managers are mostly unlikely to have a sufficient holding in a stock to materially impact a company’s financial stability. However, given the industry-wide focus on ESG, it is likely to be more often the case that investors will act together in trying to change company behaviour. This will be especially the case in controversial sectors like oil and gas, energy general and transport.
I believe that active stock and bond selection, based on thorough financial and ESG research, can help build portfolios that generate a better performance and ESG profiles than the broader market universe.
I would also argue that influencing broader positive goals is more efficient with an active management approach. If we think about the purest ESG investment portfolios – more widely known as impact strategies – these are constructed to target improvements in certain environmental or social metrics.
Strategies often cite the United Nations Sustainable Development Goals (SDGs) as target metrics – SDG examples include Climate Action, Affordable and Clean Energy, Responsible Consumption and Production, Gender Equality and No Poverty.
It is only possible to manage portfolios that have these broader societal targets in mind through an active approach based on utilising the full tool kit of research, security selection and engagement with investee companies.
Through the integration of climate science into the investment process we can now actively construct portfolios that are consistent with the global temperature target agreed in Paris in 2015 and reiterated at the 2021 Glasgow COP meeting.
ESG funds are taking an increasingly large share of investment flows – as evidenced in recent inflows. Last year a record US$649bn flowed into environmental, social and governance (ESG) focused strategies globally (to end of November) – a marked uplift on the $542bn and $285bn of inflows during 2020 and 2019 respectively.1
Pension funds, insurance companies, sovereign wealth funds and individual investors want to know that their investments are doing good. They want to be invested in the best companies – not only just from a return perspective – and they want to be sure their investment managers are taking into account how a business fares in its impact on the environment, on workers and communities, and that its management is held to account. Active management can deliver that. It can deliver good risk-adjusted rewards and help in the effort to minimise harm done to the environment and to the broader human community.