Have you read any studies in to ESG investing recently? If you have, then you’ll know that across the board, academic studies continue to stress the positive alpha-generating potential of ESG factors. Research demonstrates that there are positive links across all three environmental, social and governance factors. So, with this in mind, the solution is clear. Screen your investment universe based on ESG scores at the outset of your investment process…right? Wrong.

ESG screening tools provide us with big data sets that are useful for doing academic research and making generic assessments, but we have to be careful how we deploy them in practice. Far from perfect, the broad scope of the screens provides bottom up sustainable investors like ourselves with problems if we don’t use our initiative as well.

We discussed these issues in previous soapboxes (here and here). But just to recap, the problems of using ESG screens in isolation include:

  1. What impact does it have? – The screen provides limited or no assessment of product impact
  2. Where is the data from? – ESG data quality can be poor – inconsistent and self-reported
  3. One size fits all? – The screens follow a cookie cutter approach (every company is different but is treated the same)
  4. Large cap bias – Small or mid-sized companies are not covered or are harshly treated
  5. Geographic bias –  Emerging market companies are not covered or are harshly treated
  6. A leopard never changes its spots – They are point-in-time measures and inherently backward looking

Don’t get me wrong, ESG screens are useful for flagging potential risks. The scores produced are fairly likely to align with our bottom up assessment when considering an established, large cap, developed market company. But an ESG screen NEVER makes our decision for us. We use them, but we don’t abuse them.

So there you have it. That’s why we choose not to pre-screen our opportunity set using ESG scores. For us, it’s important to do bottom-up analysis first. And our own sustainability analysis focuses on two other key components- materiality and intentionality. So what is important for this business and does the management have ambitions to improve things? And with this open-minded approach, what do you get? Insights that you wouldn’t have without the human, active management, analysis. Typically our most valuable insights are missed by the ESG screens due to the factors above.

We always find it exciting to identify companies that have embedded a sustainable mind-set in their strategic vision… not just to reduce risks, but to create revenue opportunities as well as creating competitive advantages. Interestingly, recent research indicates that ESG is actually more powerful when combined with traditional fundamental factors (rather than in isolation) and this effect is amplified in ‘risker’ areas of the market. So what’s the inference here? That small cap, mid cap and emerging markets are the best suited to leveraging detailed sustainability analysis while complementing traditional analysis.

Our representative sustainable investment portfolios go where most other sustainable strategies don’t, and this can mean our sustainable portfolios score poorly on ESG screens- but that isn’t our primary concern.

So whilst we’re on our horse analogy, perhaps I could extend it a little and suggest that we are the Lone Ranger of sustainable strategies.  We clearly don’t gallop with the herd and like any Hollywood Lone Ranger, sometimes, to be a good guy you need to split from the herd.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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