ESG data is not financial data. We’ve covered the key shortcomings of ESG data in the past, including their problems with reliability, frequency, breadth, and depth. But with such formidable challenges, what are investors to do?
Considering that no approach can single-handedly and fully address these issues, we believe investors should seek a variety of complementary approaches among their managers. That said, there are two key practices that work well on their own, and even better in combination: using stable ESG characteristics and optimizing ESG outcomes at the portfolio level.
Seek Stable ESG Characteristics
Employing stable, non-ESG characteristics for ESG ratings allows for thorough and extensive back-testing because they can be extrapolated to a longer history than is available from the ESG ratings providers. For example, does a particular sector have a predictably low rating, or does incorporating a heavy E, S, or G tilt likely result in persistent exposure to a specific common risk factor? Identifying stable characteristics in this manner allows for more robust historical analysis than is available from the ESG data providers themselves.
Plus, stable characteristics allow you to harmonize ESG ratings models; indeed, stable ESG characteristics are more portable than ratings themselves. For example, tilting a portfolio in a way that directly targets a boost in the ESG profile measured by the MSCI ESG ratings, through identification and use of these stable characteristics, will also tend to boost the ESG profile of the portfolio as measured by Sustainalytics. This is not necessarily the case if a manager uses only the stock-specific ratings instead.
Focus on Portfolio-Level Results
Early approaches to ESG integration tended to rely heavily on negative screens in order to exclude offending companies from the investable universe. But this can be short-sighted.
For example, including a stock with an exceptionally low ESG score in the portfolio may seem counterintuitive in a positive ESG-tilt strategy, yet there are scenarios where such an inclusion allows for a greater overall tilt towards highly rated stocks, such that the ultimate portfolio-weighted rating as a whole ends up being higher than it otherwise would have been.
The surprisingly high frequency of such scenarios demand that you keep your eyes on the big picture. What’s more, this flexibility is essential when you’re trying to account for other, non-ESG risk constraints.
Moreover, this portfolio-centric approach directly helps address the issues of subjectivity and timeliness plaguing ESG data: if individual stocks’ ratings matter less, then uncertainties, errors and inconsistencies will often cancel out “in the wash,” assuming the broad outlines of the ESG ratings have been properly considered.
Avoid Black Boxes: Dig Deeper
You can benefit greatly from undertaking deep dives into the ESG data used in an investment process. Only then can you understand first-hand the limitations of the data and help prevent unpleasant surprises after the data have already been integrated into their process. For the same reason, it is important to evaluate thoroughly the exposures and risks inherent in ESG tilts and compensate for them through appropriate constraints or risk controls.
In our latest eBook, “Can Taking a Big Picture View of ESG Bypass ESG Data Pitfalls?,” we dig a little deeper for you. You’ll get a close examination of ESG data from a leading data provider and we’ll show you how you can use these insights in pursuit of more stable ESG characteristics and portfolio-level outcomes consistent with your expectations. Download it today.
The views presented are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. 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.
Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. As with all investments, there are inherent risks that need to be considered.
References to third party names such as Sustainalytics or MSCI ESG ratings does not constitute a sponsorship or endorsement by such entity nor does it accept any liability for damage.
Intech is the source of data unless otherwise indicated, and has reasonable belief to rely on information and data sourced from third parties.
