This blog is the third of a three-part series where we delve into an implementation framework to help you:
1) establish ESG investing goals,
2) uncover managers that align
with your preferences, and
3) measure the outcomes that you expect.
Asset owners, consultants and managers collectively need objective, standardized ESG reporting to ensure an ESG strategy is performing in line with goals.
ESG reporting should accomplish the following…
- Analyze portfolio ESG risks
- Assess effectiveness of ESG integration
- Benchmark ESG performance
- Evaluate ESG metrics at the portfolio-, sector-, issue- and company-level
This is easier said than done. Below are four issues to consider when monitoring ESG portfolios.
Benchmarking
Most investors use capitalization-weighted benchmarks to assess the performance of their ESG portfolios, including asset owners seeking to harmonize their investment preferences and non-financial preferences. Traditional benchmarks offer ESG managers favorable liquidity characteristics for controlling active risk, which may be higher than traditional strategies, depending on the particular approach.
Using an ESG index as a benchmark might help with reducing active risk exposure, but selecting one isn’t straightforward given the differences in ESG standards and construction methods that we’ve already detailed. What’s more, your manager may have difficulty targeting active risk if an ESG benchmark has unfavorable liquidity attributes.
Alternatively, your level of ESG focus may render a non-ESG benchmark unrepresentative of the investment opportunity set. In that case, you may construct a bespoke ESG benchmark to circumvent potential methodology and liquidity issues arising from ESG indexes.
Performance Attribution
Your ESG managers should have a performance attribution framework because without one they (and you) will not understand the performance impact of active ESG decisions. Even if you’re not an ESG investor, an ESG portfolio attribution framework is essential for understanding these exposures as they gain market acceptance.
“…ESG managers should have a performance attribution framework because without one they (and you) will not understand the performance impact of active ESG decisions.”
But while our industry has defined sector and style factors well in standard attribution models, it hasn’t done the same for ESG considerations. The lack of ESG issue standardization makes it challenging to use common attribution models to quantify the impact of ESG issues.
Managers can solve this in a number of ways. First, for managers whose practices correspond with MSCI’s ESG rating methodology, portfolio attribution is available from leading attribution platforms like FactSet. Other ESG managers might need to develop a custom risk and attribution model that aligns with their ESG methodologies, but this is a large, possibly impractical undertaking.
Interpretation
Comparing ESG metrics between a portfolio and its benchmark is not always straightforward. For instance, a manager’s process might generate attractive portfolio-level ESG scores due to sector weightings rather than stock selection. That might be okay with some investors concerned primarily with the overall portfolio tilt, but others might find holding low-rated positions objectionable.
Active Ownership
Increasingly, managers seek to influence behavior positively in ESG-related issues through direct contact and proxy voting. For ESG investors desiring active ownership, it can be difficult to see how these activities influence future investment decisions since the feedback loop is often qualitative. Whether the active ownership process is qualitative or quantitative, however, managers should have processes to measure successful engagement. They should regularly report on engagement activities and voting outcomes, especially those that have influenced investment decisions.
Evaluate Outcomes
This blog post on ESG implementation is the last of a three-part series helping you 1) establish ESG investing goals, 2) uncover managers that align with your preferences, and 3) measure the outcomes that you expect. For the complete implementation guide, download our most recent paper, “What to Look for on the Road to ESG.”
The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions.
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