Andy Mahony delves into the part data plays in the consideration of ESG issues when investing in managed funds

ESG data providers in the investment industry evaluate ESG factors primarily at the company level. Fund Managers can use the data to help understand the risk/return prospects of investing into a company. Index providers can use the data to construct products, which in turn can also be used as benchmarks for other managed funds. Figure 1 below illustrates very simply the procession of data from a company to a managed fund via ESG ratings.

Figure 1 ESG data flow

Note: The ESG data discussed here relates to managed funds across traditional asset classes. What is not mentioned is the data used to measure ‘impact’, or non-financial objectives. This element of ESG data is much less developed. However, the Impact Management Project and Global Impact Investing Network are two organisations at the forefront of these developments.

What are some key aspects to be aware of regarding ESG data?

There is no single, agreed way to measure ESG factors. There are dozens of data providers to choose from. Each of the providers apply different frameworks. A few of the larger and more commonly used providers include:

The ratings for a specific company could differ significantly across data providers. For example, a Fund Manager may want to include Tesla in their portfolio; one ESG data provider may rate Tesla highly, whilst another may rate it lower. All other things being equal, what percentage weighting of a managed fund should Tesla hold? Which ESG data provider is correct or most relevant? Simply put, the ESG information from data providers that feed managed funds is noisy, which leads to our discussion of the merits of active vs passive management in this space.

The following points summarise several aspects that may differ between the underlying frameworks employed by ESG data providers.

Data sources

e.g., annual company reports, corporate sustainability reports, stock exchange filings, news sources, company websites, individual directors, shareholder meeting results, non-governmental organisation research and reports. The other major issue is the availability and the gaps in the data across the global universe to enable broad comparison.

Algorithms and/or human processes

e.g., analyst opinion and additional insights, data audits, manual checks by analysts, language translations, picking up missing data, formal committee reviews vs systematic monitoring.

The building blocks that make up the final ESG rating

Broadly speaking this entails three ESG pillars > sub-categories > indicators > data points. e.g., starting with the ‘E’ from the three ESG pillars > a sub-category might be climate change > carbon emissions would be an indicator > metric tons of CO2 emissions per million dollars invested would be a data point. The following table shows examples of different sub-categories specified by commonly used ESG data providers. Note the similarities, or lack of. Underneath these sub-categories are several indicators which have hundreds of specific data points assigned to them.

Figure 2 Examples of the sub-categories specified by ESG rating providers

Validity of specific data points

Are the data points hard or soft, quantitative or qualitative, objective or subjective? The definition of subjective is ‘based on or influenced by personal feelings, tastes, or opinions.’ The definition of objective is ‘not influenced by personal feelings or opinions in considering and representing facts.’ For example, one of the data points for climate change is CO2 emissions which is quantitative and can be measured objectively. However, the measurement of corporate behaviour is more subjective and would require more qualitative analysis.

ESG category weights and materiality

What weights are applied to the ESG categories to calculate the overall ESG rating? What issues does the data provider place more emphasis on? Over what time horizon will the risks materialise? Are adjustments made to consider the industry a company operates in? The materiality of ESG factors differ across industries. Does the ESG rating separate systematic risk exposure from idiosyncratic risks? For example, the ‘E’ is more relevant in the energy sector than the technology sector given the direct exposure to fossil fuels and CO2 emissions. If a company is transitioning away from fossil fuels but is still emitting a significant amount of CO2 currently, does the company get a higher score for managing the risk better on a forward-looking basis, or will the current measure of CO2 emissions influence the rating more heavily? Is the rating taking into account the net materiality of different ESG factors?

Frequency of updates

How often are the ESG ratings updated? Is the underlying data sourced in a timely manner? Can the data then be collated and analysed efficiently? Parts of the rating process may be monitored daily or weekly, but a complete review of a company is more likely to be on an annual basis. An ESG data provider may also have triggers that necessitate a more in-depth look at a company e.g., controversies in the news.

Final rating description and interpretation

Is the rating a score out of 100? Is the rating assigned to one of 5 risk categories? A letter-based system with 7 categories? The interpretation of the final rating can lead to different conclusions, for example, does the rating allow an investor to compare it to companies in other industries, or is it only comparable against industry peers? Is it possible to compare the ratings for the underlying ‘ESG’ pillars, or only use the overall company rating for comparisons? Comparison of a company’s rating against itself through time may not be directly comparable if elements of the research process has changed.

Aside from differences in underlying frameworks of ESG data providers, the following points should also be considered when evaluating the use of ESG data within managed funds:

The quality of the ESG data at its source

An ESG rating can only be as good as the underlying data. Company disclosures are a crucial part of this. The disclosure organisations listed in our next article (Watch the Boom – Your Regulatory Compass) are tasked with ensuring ESG disclosures are consistent and relevant. One aspect to be aware of is a company’s self-reporting bias where there is a risk of greenwashing.

The depth of integration in the investment decision-making process

Investors should consider the extent to which the Fund Manager uses the ESG data. Fund Managers may use the data as a reference to supplement their proprietary research when ‘scoring’ a company. Other Fund Managers may use a combination of data from different ESG data providers on top of their proprietary research to calculate a company’s cost of capital. Some Fund Managers may use the data to rank companies and define screens that reduce the investment universe.

Construction of an index

This is relevant for index products but also managed funds that use an ESG index as its benchmark. The following table compares two S&P 500 ESG indices based off the main S&P 500 Index. Variation in portfolio construction can mean significant differences in risk and return outcomes.

Figure 3 S&P 500 Index vs two S&P 500 ESG Indices (Source: S&P Dow Jones Indices and S&P Dow Jones Indices - ESG)

Key observations:

• Less constituents in the ESG indices results in higher weightings to certain stocks, and higher concentration shown by weighting to the top 10 stocks.
• Bias towards stocks with higher market cap in the ESG indices.
• Higher allocation to information technology in both ESG indices.
• Lower allocation to industrials and utilities in both ESG indices.

Active, Passive or ETF

This is not the place to have the debate about active or passive, but just like fixed income (bond) investing we certainly lean towards active implementation in this space.

We are currently witnessing a phase of increased interest in responsible investing. Similar to technology, this is a thematic, and with it comes new funds and new strategies to capitalise on the interest.  This is where we, as investors, need to be careful. Is it simply greenwashing? Or a sales pitch to raise funds under management?

We highlighted earlier the challenges with the data, so constructing a quantitative investment process around these data points can be challenging.  When constructing indices or passive structures, the size of the universe is also critical. Concentration and liquidity of an index must be evaluated. A good example of a concentrated index which received significant inflows of money was the S&P Global Clean Energy Index. The trading volumes of Meridian Energy and Contact Energy shares were substantial in early 2021, which led to opportunities for active managers to exploit. To reduce the likelihood of volatile periods like this, S&P DJI ended up expanding the S&P Global Clean Energy Index’s target constituent count to 100 and amending the liquidity screen for constituent selection.

It is also important to understand the objective of the strategy - is it to be sustainable, is it to screen out bad companies, target good companies, invest for impact, or to outperform a specific index? The reality is, we operate in a world where the dollars flow toward the funds that perform, so sustainability of the fund structure is also critical.

We have seen strong performance from a number of available strategies but is it the ESG thematic driving the performance in market sectors? There are vast amounts of money moving into this thematic which helps support performance, but also, these strategies tend to invest in more asset-light technology type businesses, and avoid the old world economy. This broader thematic has been performing very well itself for the last 10+ years. After 30+ years of bond compression, as the cost of capital rises again, do some of these business models begin to be challenged?

So, is this performance persistent? Is there alpha in the opportunity set, or is ESG simply a subset of a broader quality measure?

From a broader investment portfolio perspective, is this a sleeve, a bit of play money, or is it core to your investment philosophy? Can you access credible strategies for all elements of your portfolio? Often your wealth and investment strategy are linked to your retirement outcomes, we can save the world in many different ways, but you may not enjoy it so much if you are still working at 90. Do you turn the lights on at night? In most of the world they are still coal fired.

Again, the jury is out on this one, but there is plenty to consider when building out an investment strategy.

The latest version of ‘Beneath the Surface of Responsible Investing’ can be found here.