Environmental, social and governance (ESG) investing has really exploded since the start of the millennium in terms of different approaches, different evidence, and different organisations getting involved, said Jane Ambachtsheer, partner, chair at responsible investment, Mercer, speaking during The complexity of ESG integration panel discussion at the annual Stoxx Innovate to Invest conference on March 30 in London.
"Ten years ago we had the launch of the United Nations principles for responsible investments (PRI) which now represents half of global assets. That's a huge growth in a relatively short period of time," said Ambachtsheer.
In 1999 the UK pension act changed to require pension funds to disclose if and how they were managing what was then called SEE (social, ethical and environmental) issues and that was the early catalyst for pushing investors to think about this issue, according to Ambachtsheer. "At the time it wasn't that complex. There weren't that many case studies. There wasn't that much literature and there weren't that many practitioners working in the field," she said.
Eighteen years on, and, according to Julia Kochetygova, senior ESG research analyst Northern Trust Asset Management, it is exciting to see how interesting and innovative the ESG space has become. "You know that you believe in a certain theme within ESG," said Kochetygova. "You believe in a certain type of growth, in a certain market trend and by doing this you believe that you are helping the environment and society but you are also doing something good for your financial returns."
Making these selections is a complex decision and investors are facing certain questions they need to answer, said Kochetygova. "First of all, are you prepared to take active risk?" In particular investors who invest most of their assets in a passive way have to ask themselves whether they are actually prepared to deviate from the standard benchmark, according to Kochetygova. "Or do you want to stay within close proximity of your benchmark, even if it does not have an ESG element?"
Just because a company manages its ESG risks well, it doesn't mean they are going to execute their competitive strategy well, according to Matthew Ross (pictured), portfolio manager, Univest Company, which is responsible for the listed equity and alternative investments of the Unilever pension funds.
"We don't necessarily feel that ESG at this moment in time is a good alpha signal, like value or momentum would be," said Ross noting that on the flipside a great company can execute very well but if they don't manage their ESG risk it can completely derail their strategy. "Look at Volkswagen, or Uber, these companies did a great job in execution but because they neglected their ESG risk it has now put their strategies in question," said Ross.
"By design we have a very minimal exclusion list which is determined only by regulation," said Ross. "We don't like to focus on what products the company is making but instead on the practices of the companies. So we don't necessarily want to exclude all fossil fuel or tobacco companies but we want the best ones that are best prepared with the unique ESG risk that these companies pose," he said.
The more ESG effect you are going to achieve, the higher the active risk, according to Kochetygova. "We often speak of the 'Tragedy of tracking error' which is kind of a curse of ESG investment," she said. "In the beginning you can achieve a high effect within a relatively small scope of tracking error while over time it is going to be increasing," said Kochetygova.
"To achieve a bigger effect always comes at a cost and many investors view this cost as very substantial." There are two ways to look at this, according to Kochetygova. "One is looking at ESG as kind of smart-beta, and when I'm talking about smart-beta I am using it in philosophical sense rather than technical sense," she said. "Basically you say, yes we are going to deviate, but we are going to invest in a better market in a future market as we see it, because we believe that ESG factors are reducing our actual risk. But you still have an opportunity to control your tracking error, to still decide where on the scale of ESG effect and sophistication and risk you are going to be.
"The second way is optimising. You give yourself a tracking error budget and you maximise your ESG effect within this budget," said Kochetygova.
Click the link to view the presentation from Mercer, Northern Trust, and Unilever.
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