Historically, the two dominant philosophical approaches to Environmental, Social and Corporate Governance (ESG) investing have been either ‘independent’ or ‘integrated’. Both are intellectually sound, but, in our experience both tend to be compromised by competing cultural factors.

By combining both, we believe there is a ‘third way’. But first let’s look at the two traditional approaches and why we believe that these are sub-optimal:

ESG integration – where fund managers consider ESG factors alongside their normal analysis – is a popular approach in modern day investing circles and is increasingly used by many general investment funds that seek to show they invest responsibly. There are a range of approaches; some are deeply embedded whilst others are very light touch. Although we support positive change towards ESG, we are cautious over the intent of the approach – clients need to be sure this is not marketing over substance.

The ESG element of the analysis that is supposed to be ‘integrated’ needs to have a proper voice within the process, not demoted to the point where it is incidental. One of the key behavioural problems stems from the lack of independence, an investor can always compromise the ESG aspects of the investment case when another aspect of it (e.g. valuation) excites them. At worst, investors simply pay lip service to ESG and consider it a burdensome tick box exercise. On the flip side, investors that are too enthusiastic about ESG – such as focused ‘impact theme’ investors – may allow a good sustainability story to outweigh negative issues within the investment case such as a weak business model or excessive valuations. Paying too much attention to the things that ‘sound good’ can be as dangerous as ignoring sustainability altogether.

Independent ESG research is typically deployed by large investment firms or at specialist ESG funds. These, often large, ESG research teams may undertake detailed analysis on companies owned in clients’ funds. This is great, but the problems arise when ESG research happens in a siloed fashion separate from investment management. For example, an ESG edict ordering a manager to sell their holding in a particular company does not work. Even if the justification is valid, such an approach results in a culture of frustration, resistance and cynicism. Frustrated managers often end up complaining that their investment universe is unfairly restricted and that this is negatively impacting their performance. Ultimately such an approach can lead to regressive attitudes towards something that benefits everyone.

The Third Way. We strongly believe in both the independence and the integration of sustainability analysis. We have a small ESG research team that works closely with the investment team. When the investment team is particularly interested in a new investment idea, the ESG research team undertake their research in parallel.

For the Kames Global Sustainable Equity Fund, by working with the ESG research team collaboratively, we see the value in what they do and we think it helps us uncover different nuances along the way. Our close working environment ensures we are more than happy to accept their independent view.

We all learn more with this approach.

Sustainability analysis is an important tool in our investment process… ultimately we see it as a progressive alpha-generating layer of due diligence that many investors miss.

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