Measuring the strength of a company’s ESG characteristics is becoming an increasingly important part of investors’ assessing of risk and return, with consumers and policymakers increasingly applying pressure for greater sustainability, and a rising body of systemic evidence pointing to a correlation between the ESG characteristics of companies and their forward return performance.
But measuring a company’s ESG characteristics and accessing the data required for this is an involved exercise, says Mozaffar Khan, vice president of Causeway Capital Management, warning against over-reliance on off-the-shelf third-party ESG ratings.
“I think it’s certainly useful to have a third-party issue ratings as an input into a manager’s view,” said Khan, speaking at the Investment Magazine Fiduciary Investors Symposium on
“But then we have to go a bit deeper and you know, we have to look at these third-party ratings and ask what is included in these ratings and are there material ESG issues that are you know, either omitted or underemphasised in these ratings.”
Khan’s research finds some material factors are typically omitted or underemphasised in governance ratings. For example governance ratings can focus on board of director characteristics while neglecting the strength of investor protections and institutions in a country.
After identifying these factors, quantifying them can involve novel solutions and proxies for measuring exposure, particularly with issues like modern slavery which are not directly observable.
When assessing the ESG strengths of a manager, Khan said it was important to look at the manager’s commitment to ESG.
“Do they have an evidence-based belief on the relation between ESG and alpha?” Khan said. “And…look at how thoughtful their processes are. Are their analysts trained on the issues? Have they developed tools internally to help facilitate the integration of ESG issues in investment analysis? And are their analysts aligned? Is there some accountability in terms of integrating ESG issues?”
Cheryl Smith, an economist and portfolio manager and research analyst with Trillium Asset Management, owned by Perpetual, pointed out how widely ratings agencies differ in how they rate companies, and posed the question whether this means ESG data is unreliable in distinguishing between companies? And does getting this right lead to better alpha or does the market already incorporate this information?
There is widespread academic data supporting the positive impacts of incorporating ESG data, Smith said, along with the mandate given by participants in a fund. But it is crucial to look for the appropriate data to suit your purpose rather than stop at “well-behaved data”.
“It’s a very big temptation to look at what can be measured, but that’s looking for your keys under the lamppost instead of trying to think about where you actually dropped the keys as you’re trying to figure this out,” Smith said.
“The measure of ESG performance has to be with respect to the question and again to the motivation of why you’re looking to incorporate that ESG data. Are you trying to enhance performance, reduce the variability of returns, or are you trying to meet policy goals, or are you trying to do all of those?”
You can see the full interview on the Fiduciary Investors Symposium digital hub.