E, S or G: Which should schemes prioritise?
While there has been significant and increasing interest in environmental, social and governance issues among pension funds, there has not broadly been a corresponding increase in the nuance of integrating these factors in building and managing portfolios.
Rather, we have seen a persistent desire for simple, binary answers – such as, for example, ESG outperforms or it underperforms; or, it is all about E or S or G and not the other factors.
Mining E and S factors for sources of incremental investment insight can be a more additive effort than doubling down on legacy G-related efforts
ESG integration is an investment question. As an investment question, the use of ESG factors parallels the use of other investment tools – it requires care, nuance and skill in order to drive value in portfolios.
Similarly, its application varies across geographies, investment styles, asset classes, and the ebbs and flows of markets. Applying ESG integration in a blanket fashion would be no different than, say, investing only in companies with a price-to-book ratio of less than two.
So how can schemes use ESG integration?
We advocate approaching E, S and G factors with nuance and distinction, to understand specifically where these investment tools can help drive returns and manage risk in an investment portfolio. The most value can be found in applying ESG integration at the intersection of three elements, specifically instances where:
- ESG factors are material for risk and return
- ESG is not already thoughtfully incorporated (ie priced) into your portfolio
- ESG factors may not be well covered or understood (ie priced) in the broader markets
To the question of whether schemes should prioritise E, S or G, we find that all three factors meet the test for the first element, materiality, albeit with significant variance across asset classes, geographies, sub-sectors and companies.
Some of this materiality is persistent – for example, we find ongoing value in resource efficiency in manufacturing (E), and supply chain transparency in emerging markets (S), while in other instances materiality may be more time bound, such as scrutiny of the Dakota Access Pipeline in the United States (E).
Managers improving stewardship disclosure, but ESG has a way to go
Quality of stewardship reports among asset management firms is steadily improving, according to the Financial Reporting Council, but some managers continue to dismiss environmental, social and governance issues.
However, we find that governance generally receives more consistent treatment by fiduciaries – hence it does not as frequently meet the second element, as it is already incorporated by investors – and is better covered by external resources and other market participants, and therefore also less frequently meets the third element, as it is already incorporated by the broad market.
As such, mining E and S factors for sources of incremental investment insight can be a more additive effort than increasing legacy G-related efforts.
Finding the right factor can make the difference
To give an example, one emerging market equity manager we work with detailed his decision to avoid an Indian pesticide producer that he had initially found financially attractive.
What drove this decision was in-depth ground diligence, which discovered that the company’s sales were heavily driven by the use of a chemical compound banned in several developed markets due to its negative effects on biodiversity and health.
This E factor met the three elements above – it was a material financial risk, it was not already priced in by the investor, and it had not been widely discovered by the market.
Is it time for DC defaults to embrace ESG?
Large defined benefit funds and defined contribution mastertrusts have long been using their investments to engage with or divest from companies involved in controversial practices. Now, a renewed public focus on environmental, social and governance issues, as well as corporate reporting, could convince more to follow.
Four years after this initial decision to avoid investment, the chemical was banned in India, causing the company's stock price to plummet. An E factor happened to be most material in this instance – but this does not hold true as a blanket statement.
Four years after this initial decision to avoid investment, the chemical was banned in India, causing the company’s stock price to plummet. An E factor happened to be most material in this instance – but this does not hold true as a blanket statement.
Instead of focusing on an individual factors within ESG, schemes should focus on utilising the right factor for the right reasons in order to drive material value in their portfolios and for beneficiaries. ESG integration is a powerful investment tool when used with the nuance and skill befitting it.
Kathleen Hughes is global head of liquidity solutions sales and European head of the institutional sales business at Goldman Sachs Asset Management