The importance of responsible investing has increased substantially in recent years and is gradually entering the mainstream investment arena, set to become an irreversible trend.
Recent events – such as the BP oil spill, the accounting scandal at Olympus, the collapse of an apparel factory in Bangladesh, and ongoing global concerns about the environment – illustrate that environmental, social, and governance factors can have a significant impact on a company’s share price performance and hence on investment portfolios.
Therefore, integrating ESG factors into the mainstream investment process is essential for optimising the risk–return characteristics of one’s portfolio.
One of the reasons that RI took years to be accepted is the misperception that investing in a responsible way (which in the past mainly meant excluding certain investments from an ethical perspective) would actually reduce the investable universe and thus have a negative impact on investment performance.
For this reason, some argued that considering ESG factors in the investment decision making process would be in violation of the asset manager’s fiduciary duty to maximise investment returns. But many studies have shown that incorporating ESG factors improves the downside protection while potentially improving the upside as well, and in any event, it should improve the risk–return characteristics of an investment portfolio.
Other studies have shown positive correlation between ESG-score improvements and share price outperformance. All these findings make perfect sense because the goal of investing in a responsible way is to look for sustainable business models, which often result in a company having a competitive edge and being able to achieve superior returns.
Consequently, inclusion of ESG factors should be perfectly in line with an asset manager’s fiduciary duty as well. Furthermore, integrating ESG factors can – and should – be seen as simply being a more complete approach to investing. This realisation is gradually leading to an increasing focus on the analysis of ESG factors in the overall investment process.
Today, the rise of social media has made reputational risks for asset managers potentially greater. Integrating ESG factors in the investment process can help asset managers guard against reputational risk in several ways. RI should drive asset allocation toward more sustainable business models, which should have a positive effect on society and the environment.
Note that RI should not be only about excluding certain companies but rather about finding out which companies do well (or are improving) when ESG factors are analysed. As this realisation is gradually growing, the market is slowly moving away from an approach driven by exclusion only.
For asset managers, the topic of ESG integration is also becoming increasingly important from an asset-gathering perspective. Large asset owners such as pension funds increasingly demand proper ESG integration into the investment process or view ESG integration as one of the important factors when deciding which asset manager will receive their business.
This trend is likely the result of pension funds becoming more aware of their reputational risks, more responsible and eager to reflect their values and beliefs, and more aware of the risk–return optimisation that ESG integration brings to their investments.
Today, there is an emerging trend in which separate ESG teams provide an ESG overlay to the “mainstream” analyst’s research or the portfolio manager’s investment process. To accomplish true ESG integration, however, one should make ESG an integral part of the investment analysis performed by the mainstream analysts and an integral part of the overall investment process. This integrated approach is likely to become more widespread over the next decade.
Jeroen Bos, CFA, is the head of global equity research at ING Investment Management and a member of the board of directors of CFA Society Netherlands