Investors can gain a competitive edge by demonstrating a deep integration of ESG analysis in a systematic and comprehensive way.
There is still work required to shift the investor mindset from reputational risk as the highest ESG concern to financial risk. At a time when less than a third of asset managers show leading ESG integration – according to the RIAA Benchmark Report – the opportunity exists for investors to demonstrate superior expertise.
Moreover, RIAA highlights a gap between the 28 per cent of surveyed asset managers who apply a leading approach to ESG integration and the 50 per cent who acknowledge the impact of ESG factors on performance.
If the connection between integrating ESG factors and performance exists, then there is strong incentive to adopt leading integration practices. The gap may represent the opportunity for managers to apply their expertise to improve performance, or it may be that respondents consider reputational risk as a key performance impact.
The aim of integration is the identification of financial returns-related risks and opportunities not necessarily captured by traditional investment analysis.
However, for some investors, the financial returns driver of ESG integration has been overshadowed by reputational risk. Reputational risks tend to relate to the bad behaviour of the company measured through the lens of global norms and principles of behaviour, such as the UN Global Compact.
In recent years, knowledge of the relationship between ESG integration and financial returns impact has improved.
Research has established the connection between ESG risks and portfolio risks. MSCI has identified two important differentiators of ESG analysis that can impact performance. First, analysis must focus on identifying risks that can affect company value, and second, it must assess the management of these risks. Not all ESG research adopts these two principles.
The live performance of ESG indexes also provides evidence of the outperformance of ESG strategies. The MSCI ACWI ESG Leaders index has outperformed the market capitalisation benchmark, MSCI ACWI, in 9 out of the last 11 years.
The index selects companies by ESG factors that aim to capture financially material risks and opportunities. Other indexes focus on climate themes, screening, impact, and factors. ESG indexes can be used to benchmark the ESG integration of funds.
Asset managers who actively select investments should be on top of all company risks and opportunities in their fund, both in terms of traditional analysis and ESG analysis.
However, if only half the RIAA investors surveyed see the impact on performance as a key driver of the adoption of ESG Factors, then the other half may argue that more pressing issues require their attention, like interest rates and commodity prices.
If that is at the expense of integrating ESG factors, then it leaves asset owners who adopt the principle of ESG integration with a dilemma. What side of the coin toss lie their managers beliefs? Heads they believe ESG factors impact performance, or tails they do not?
Asset owners can control the odds by writing investment policies and mandates specifying ESG benchmarks and ESG factor thresholds. This proactive approach dictates the asset owner’s expectations, avoiding the uncertainty. Amending investment policies and mandates with specific and quantifiable aims and benchmarks may be challenging but would provide clear guidance and require investors to take ESG integration more seriously.
Michael Salvatico, is executive director at MSCI ESG Research